Dow Theory was first conceived and developed at the end of the 19th Century by Charles Dow, who along with Edward Jones and Charles Bergstresser founded the Dow Jones Industrial Average in 1896. While Dow Theory was developed by Charles Dow, he was unable to complete his ideas around this as he died in 1902. it was later expanded upon by by William Hamilton in the 1920s, Robert Rhea in the 1930s, and E. George Shaefer and Richard Russell in the 1960s.
So what is Dow Theory? Dow Theory is a trading methodology that is based on the efficient market hypothesis. Charles Dow believed that the market was - in aggregate - a good indicator or measure of the the state of the economy or confidence in the economy. Therefore, if one could analyze the overall market, one could identify trends that could forecast the direction of the market and individual stocks.
Part of the analysis included an observation that markets experience three layers of trends. The primary layer or trend is that markets are either in a bull or a bear market. Within each of the latter primary trends there are secondary trends working against the primary trend such as pullbacks or rallies, but these occurr in the context of the primary trend which prevails while in motion. These secondary trends can last from 3 weeks to several months. Lastly there a tertiary trends which are minor and may last for a week or two or three and represent static noise.
A Primary trend has three phases. According to Dow Theory, a primary trend will pass through three inevitable phases. In a Bull market, these are the accumulation phase, the participation or retail phase and the excess or what might be described as a "melt up" phase. In a Bear market, the phases are described as: a distribution phase, the public participation in the sell-off phase and the panic or despair phase.
Trends need to be confirmed. In other words if the market is in what appears to be a bull or bear market, the trend must be objectively confirmed. The way they saw these trends being confirmed is by looking at several key averages or market indices confirming one another. In other words the key indices or averages would mirror each other eventually either moving up in a bull market or moving down in a bear market. If market indices are showing a divergence, meaning for example, one index is going up but another one or more is not, this would mean that a "primary trend" or "change in primary trend" has not been confirmed.
To further validate a "trend" the volume would need to support the trend. In other words in a rising market you would expect volume to be rising. If it is not, it would suggest that the "trend" is again not sustainable. In a falling market you would expect volume to capitulate and dry up. If volume was to pick up while the market it falling, it would suggest again that the "trend" is not sustainable. Dow Theory postulates that until there is a clear reversal or change in the trend, the primary trend persists.
At the time Charles Dow lived, the Railways were a primary indicator of economic activty faciliating the movement of goods and raw materials. He and his partners had invented two leading market indicators: The Dow Jones Industrial Average (DJIA) to track the overall or aggregate market activity and the Dow Jones Transportation Average (DJTA) to track the freight business. The rational assumption was that a healthy gwowing economy and stock market would be reflected in a rise of the DJTA as the transportation business would inevitably be benefitting as a result. If the markets were rising but the DJTA was not, it would suggest that the trend was not sustainable or grounded in real commercial data and thus the overall market direction was not sustainable. In such an example, the primary direction or trend would not be confirmed.
The principle can be applied in reverse as well. For a primary trend to be confirmed whether it is a bull or bear markets, it has to be confirmed by multiple indices.
In todays sophisticated economies with numerous complex market averages or indices and complex algorithmic trading it requires rigorous analysis to put Dow Theory to work.
Trends inevitably change from Bull to Bear to Bull markets. Being able to develop a methodology that can show changes in the primary and secondary trends can of course be very profitable whether it is in market averages or individual stocks.
Is Dow Theory still relevant today? The primary trends identified by Charles Dow eerily repeat. Dow Theory may need to be applied and thought about differently today but has a great deal of relevance and fact associated with it. Dow and Jones were pioneers and it is not a surprise that the Dow Jones Index is known throughout the financial world.