What you should know about the Dow Theory

important points

  • Dow theory was developed by Charles H. Dow.
  • The Dow Theory has six parts.
  • The stock market has three main trends.

Dow Theory, developed by Charles Dow, is a set of theories about how financial markets have evolved over time. It is used primarily in technical analysis, but long-term investors can also use Dow Theory to discover buying and selling opportunities to lower their cost base on specific investments. Dow Theory consists of six main components.

1. The market discounts all assets

One of the basic assumptions of Dow Theory is that markets operate efficiently. In other words, all stock prices are based on all available information about the company. The company’s earnings, its management, its competitive advantages and weaknesses, and everything else goes into the price, regardless of whether the individual investor knows this information.

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2. The market has three main trends

Dow Theory assumes that the market has three directions. The first trend lasts longer than a year and is usually classified as a bullish or bearish market. Bull markets are times when stock prices are rising and bear markets are times when stock prices are down. The second type of trend occurs within the main trend, often goes against it, and lasts up to a few months. Think corrections or pullbacks during bull markets or rallies during bear markets. The latest trend occurs in daily price movements or trends that last only a few weeks.

3. Primary directions can be divided

The third part of Dow Theory states that you can divide the initial trends into three phases. When it comes to a bull market, the three stages are:

  • accumulation phase
  • public participation stage
  • surplus stage

When it comes to a bear market, the three stages are:

  • distribution stage
  • public participation stage
  • panic stage

4. Averages must confirm each other

Dow created averages – Dow Jones Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA) – based on the idea that one should reflect the state of production (DIJA) and the other should reflect the movement of these products in the economy (DJTA). According to the Dow Theory, the height of one should be reflected in the height of the other. In this case, if the economic situation is good (which is reflected in the rise of DIJA), the transfer index should also benefit from this rise. If not, the trend is unsustainable.

In today’s economy, industries may differ, but the relationship between complementary industries remains the same.

5. Trends are confirmed by size

According to the theory, when the price moves in the same direction as the main trend and vice versa, the total volume should increase. When the volume is low, it means that the trend is weak. In a bull market when prices are rising, volume should increase, while in minor corrections or pullbacks, volume should decrease. If volume increases during a pullback, it could mean that the trend is reversing and investors are becoming more bearish.

6. Trends continue as long as there is no definitive reversal

Aside from the daily fluctuations in stock prices, Dow believes that prices move in trends. Although changes in trend are next to impossible to predict, Dow Theory assumes that the trend will continue unless there is clear evidence of a reversal.

Use theory to achieve your long-term goals

Some traders use technical analysis such as the Dow Theory merely as motivation for their trading. At The Motley Fool, we prefer a fundamental approach that looks at the business behind each stock individually.

But even if you don’t use Dow Theory to trade, it can help you achieve your long-term goals – especially when it comes to breaking market trends like bear markets. Understanding bear market stages can help you avoid panicking when you see your portfolio going down because you will realize that not only are these trends common, but almost inevitable if you invest long enough.

One of the most important components of Dow Theory is the “panic phase” during a bear market. As a long-term investor, you should not be alarmed by a bear market, instead view it as an opportunity to prepare for the future by picking some of your favorite investments at a “cheap” price. Your cost basis is the average price you pay per share in a company or fund. The ability to lower your cost base during a bear market is great for investors because it increases your profits if you sell shares in the future.

Use Dow Theory to determine market trends, not try to time the market. Warren Buffett said best: “Be afraid when others are greedy, and greedy when others are afraid.”

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