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
- 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).
- 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).
- 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.
- 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.
- 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.
- 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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