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Dow Theory Basic Tenants


Charles Dow & Edward Jones founded Dow Jones & Company in 1882. Technical Analysis has its origin in theories published by Dow in series of editorials he wrote for the Wall Street Journal. Dow Theory still holds good in age of sophisticated computer technology. Dow created two separate index that would provide good indication of health of economy, Industrial Index and Stock Rail index. Dow relied on closing prices and did not consider intraday penetrations valid.

There are six basic tenants of Dow Theory. They are :-

  1.  Averages Discount Everything - Sum and tendency of the stock exchange represent the sum of all stock markets knowledge of the past, immediate and remote, applied to the discounting of the future. Markets cannot anticipate only natural calamities, but even those are discounted quickly as and when they occur.
  2. Market has Three Trends - Dow defined uptrend as a situation in which each successive rally closes higher than the previous rally high and each successive rally low also closes higher than the previous rally low. In other words uptrend has higher tops and higher bottoms. Opposite situation of lower tops and lower bottoms defines a downtrend. Dow believed that laws of action and reaction apply to markets just as they do to the physical universe. Dow considered trend to have three parts; primary, secondary and minor, which he compare to tide, waves and ripples of the sea. An observer can determine the direction of tide by noting the highest point on the beach reached by successive waves. If each successive wave reaches further inland than the preceding one the tide is flowing in. When the high point of each successive waves recedes, the tide is ebbing.
  3. Major Trends have three Phases - Accumulation, Participation & Distribution are the key phases in major trends. In the accumulation phase the informed insiders know that in the current downtrend, markets have fully discounted the bad news, they accumulate at discounted prices. Public participation phase starts when prices are rising rapidly and now even the business & economic news is improving. Distribution phase starts when all the media carries bullish headlines, there is speculative buying on huge volumes. During this last phase the same informed investor who began accumulating near the bear market bottom, begins to distribute before anyone else starts selling.
  4. Averages must confirm each other -  Dow while referring to Industrial and Rail averages meant that no important Bull or Bear market signal could take place unless both averages gave the same signal thus confirming each other.
  5. Volume must confirm the Trend - Volume is secondary but important factor in confirming price signals according to Dow. Volume should expand in the direction of the major trend. Volume should increase as prices move higher in uptrend. Similarly volume should also increase as prices move lower in downtrend.
  6. Trend is intact till proven otherwise - It relates to physical law of market movement, which states that an object in motion tends to continue in motion, until some external force causes it to change direction. There are many trend reversal signals now, like support/resistances, price patterns, trend lines, moving averages. Some indicators can also provide warnings of loss of momentum.