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Technical Analysis -- The Dow Theory



 

Dow Theory is a theory on stock price movements that provides a basis for technical analysis. The theory was derived from 255 Wall Street Journal editorials written by Charles H. Dow (1851-1902), journalist, founder and first editor of the Wall Street Journal and co-founder of Dow Jones and Company. Following Dow's death, William P. Hamilton, Robert Rhea and E. George Schaefer organized and collectively represented "Dow Theory," based on Dow's editorials. Dow himself never used the term "Dow Theory," though.

The six basic tenets of Dow Theory as summarized by Hamilton, Rhea, and Schaefer are described below.

Six basic tenets of Dow Theory

  1. Markets have three trends
    Dow defined an uptrend (trend 1) as a time when successive rallies in a security price close at levels higher than those achieved in previous rallies and when lows occur at levels higher than previous lows. Downtrends (trend 2) occur when markets make lower lows and lower highs. It is this concept of Dow Theory that provides the basis of technical analysis' definition of a price trend. Dow described what he saw as a recurring theme in the market: that prices would move sharply in one direction, recede briefly in the opposite direction, and then continue in their original direction (trend 3).
  2. Trends have three phases
    Dow Theory asserts that major market trends are composed of three phases: an accumulation phase, a public participation phase, and a distribution phase. The accumulation phase (phase 1) is a period when investors "in the know" are actively buying (selling) stock against the general opinion of the market. During this phase, the stock price does not change much because these investors are in the minority absorbing (releasing) stock that the market at large is supplying (demanding). Eventually, the market catches on to these astute investors and a rapid price change occurs (phase 2). This occurs when trend followers and other technically oriented investors participate. This phase continues until rampant speculation occurs. At this point, the astute investors begin to distribute their holdings to the market (phase 3).
  3. The stock market discounts all news
    Stock prices quickly incorporate new information as soon as it becomes available. Once news is released, stock prices will change to reflect this new information. On this point, Dow Theory agrees with one of the premises of the efficient market hypothesis.
  4. Stock market averages must confirm each other
    In Dow's time, the US was a growing industrial power. The US had population centers but factories were scattered throughout the country. Factories had to ship their goods to market, usually by rail. Dow's first stock averages were an index of industrial (manufacturing) companies and rail companies. To Dow, a bull market in industrials could not occur unless the railway average rallied as well, usually first. According to this logic, if manufacturers' profits are rising, it follows that they are producing more. If they produce more, then they have to ship more goods to consumers. Hence, if an investor is looking for signs of health in manufacturers, he or she should look at the performance of the companies that ship the output of them to market, the railroads. The two averages should be moving in the same direction. When the performance of the averages diverge, it is a warning that change is in the air.
    Both Barron's Magazine and the Wall Street Journal still publish the daily performance of the Dow Jones Transportation Index in chart form. The index contains major railroads, shipping companies, and air freight carriers in the US.
  5. Trends are confirmed by volume
    Dow believed that volume confirmed price trends. When prices move on low volume, there could be many different explanations why. An overly aggressive seller could be present for example. But when price movements are accompanied by high volume, Dow believed this represented the "true" market view. If many participants are active in a particular security, and the price moves significantly in one direction, Dow maintained that this was the direction in which the market anticipated continued movement. To him, it was a signal that a trend is developing.
  6. Trends exist until definitive signals prove that they have ended
    Dow believed that trends existed despite "market noise". Markets might temporarily move in the direction opposite the trend, but they will soon resume the prior move. The trend should be given the benefit of the doubt during these reversals. Determining whether a reversal is the start of a new trend or a temporary movement in the current trend is not easy. Dow Theorists often disagree in this determination. Technical analysis tools attempt to clarify this but they can be interpreted differently by different investors.

Analysis

As with many investment theories, there is conflicting evidence in support and opposition of Dow Theory. Alfred Cowles in a study in Econometrica in 1934 showed that trading based upon the editorial advice would have resulted in earning less than a buy-and-hold strategy using a well diversified portfolio. Cowles concluded that a buy-and-hold strategy produced 15.5% annualized returns from 1902-1929 while the Dow Theory strategy produced annualized returns of 12%. After numerous studies supported Cowles over the following years, many academics stopped studying Dow Theory believing Cowles's results were conclusive.

In recent years however, some in the academic community have revisited Dow Theory and question Cowles' conclusions. William Goetzmann, Stephen Brown, and Priyank Kumar believe that Cowles' study was incomplete [1] and that Dow Theory produces excess risk-adjusted returns.[1] Specifically, the absolute return of a buy-and-hold strategy was higher than that of a Dow Theory portfolio by 2%, but the riskiness and volatility of the Dow Theory portfolio was so much lower that the Dow Theory portfolio produced higher risk-adjusted returns according to their study. The Chicago Board of Trade also notes that there is growing interest in market timing strategies such as Dow Theory. [2]

One key problem with any analysis of Dow Theory is that the editorials of Charles Dow did not contain explicitly defined investing "rules" so some assumptions and interpretations are necessary. And as with many academic studies of investing strategies, practitioners often disagree with academics.

Many technical analysts consider Dow Theory's definition of a trend and its insistence on studying price action as the main premises of modern technical analysis.

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