Dow Theory: Meaning, Importance and Limitation

The financial world evolves at a phenomenal pace, and new theories pop up regularly. However, amidst the chaos, one figure stands out for his pioneering work: Charles H. Dow. Born in 1851, Dow was a journalist and the founder of The Wall Street Journal. He made significant contributions to the field of technical analysis. 

During the late 19th century, Dow co-founded Dow Jones and Company with Edward Jones and Charles Bergstresser. Here, they envisaged the journey to develop a comprehensive system for analysing and understanding the stock market. 

In 1884, Dow formulated the first stock index – the Dow Jones Industrial Average (DJIA). This index aimed to capture the performance of the U.S. industrial sector. It initially comprised 12 prominent companies across various industries such as oil, chemicals, sugar, rail, and electricity. The composition of the index has changed multiple times since its inception and it now includes 30 companies which are not necessarily limited to the industrial sector. The index has now become an enduring symbol of the American economy’s vitality. 

Dow scrutinised daily price movements and trends and sorted patterns and correlations. These later led to the publication of the Wall Street Journal in 1889, which is also considered the financial bible for investors and traders across classes. Though Dow himself didn't formally compile his theories, his insights laid the groundwork. It was his followers—William Peter Hamilton, Robert Rhea, and E. George Schaefer—who compiled editorials and gave us what we now recognise as Dow Theory.

This chapter marks the beginning of our series on technical indicators. It explores the groundbreaking Dow theory in detail and touches upon its origin, evolution, significance, and limitations.

What Is Dow Theory?

The Dow theory is a significant technical analysis tool that emerged through the diligent observation of market behaviour. It argues that market movements can be studied, analysed and predicted. Dow Theory is built on several core principles, one of which is the idea that markets and indices effectively absorb and reflect all available information at any given time. This theory also posits that market movements can be categorised into three major trends.

Other core tenets of the Dow Theory are market confirmation and sector analysis. Dow believed that the broader markets could be ascertained by examining the performance of different sectors. For instance, if the DJIA exhibited strength and upward momentum, it was an indication of a healthy market. 

Dow’s selection of the 12 companies for the DJIA was deliberate and strategic. He sought to create a representative sample of all the major industries that drove the American economy at the time. This would offer a comprehensive snapshot of the market’s performance and help ascertain economic health. 

Key Principles of the Dow Theory

Below are the basic tenets of the Dow Theory:

• The Discounting Nature of Indices

According to the basic principle of this theory, indices and markets encapsulate the actions of millions of traders, investors, and speculators. As a result, they discount, account and reflect all known and foreseeable events that may impact the supply and demand of individual stocks and their prices. 

This is in line with the Efficient market hypothesis (EMH), which propagates that stock prices reflect all available information. Take the US elections, for instance. Now, per the Dow Theory, the indices have already discounted the anticipated market disruptions. 

This principle is often cited against the critics of technical analysis. The argument is that if the markets have indeed incorporated all news and information, then the only way to beat it is through technical analysis!

• Trends in Price Movements

This is the most crucial tenet of the Dow Theory, which states the market moves in 3 broad trends, which are as follows – 

• Primary trend:

The primary trend is the trend that is most dominant and long-term in nature, lasting at least a year (may also extend several years). This type of trend can be upward or downward and describes the broader direction of the market. 

If the trend is upward or a bull run is currently taking place, it can be demarcated into 3 phases. 

• The accumulation phase:

This phase occurs when investors purchase or start ‘accumulating’ stocks at lower rates from distressed sellers. This can happen when the market is typically in a foul mood due to a negative macroeconomic event or any other reason. If the market is experiencing a slow movement, then with the onset of the accumulation phase, the activity gradually starts to pick momentum. 

If the market can find buyers at a lower price, it can stabilise the stock prices and prevent them from falling further, thereby creating support levels. 

• The advancement phase:

In this phase, the interest of market participants and large institutional buyers, alongside growing trade activity, can cause the prices to rise. Here, the stock prices may see a sharp and rapid rise, which may lure the public’s interest. 

• The excess phase:

Per the name, this phase may be characterised by the ‘excess’ interest and participation of the public in the market and can also see the stock prices rise phenomenally. Valuations may be sky-high during this phase. 

Now, as stock prices breach new heights, investors may soon start off-loading the stock to book profits. This can, in turn, trigger a downtrend or a bear run. 

Now, the bear run can also be classified into three phases. 

• The distribution phase:

The distribution begins when investors from the accumulation phase start dumping the stock back into the markets. As more and more investors join the trend, it may cause the prices to decline (though not very sharply). 

• Panic phase:

As the name suggests, prices plummet as a sense of panic starts to develop in the markets. The offloading of stocks may continue with high intensity and sizeable supporting volume.

• The final phase:

In this phase, the buyer who held the stock during the panic phase starts to offload. It may not be as intense as the other 2 phases. 

The final phase again sets the stage for the accumulation phase, and the cycle continues. Note that these phases may not typically happen over weeks but over years. 

Take a look at this image - 

• Secondary trend:

Challenging to identify, the secondary trend represents movements that oppose the primary trend. This type of trend may last anywhere from a couple of weeks to a few months. Do note that the secondary trend may retrace at least 1/3rd of the previous price movement. Imagine a bear market with minor corrections and recoveries. 

• Minor trend:

The minor trend represents the day-to-day fluctuations in the market. They may not significantly impact the markets or the primary and secondary trends. 

• Confirmation Through Indices

A crucial tenet in Dow Theory is the confirmation of trends by the Dow Jones Industrial Average and Dow Jones Transportation Average. This principle believes that both averages should move in the same general direction to validate a trend. 

If the two averages diverge, it may cast doubt on the validity and strength of the trend.  For example, if the Dow Jones Industrial Average is in a downtrend and the Dow Jones Transportation Average is in an uptrend, then the trend cannot be confirmed. In other words, one index cannot be used to verify or doubt market mood. 

• Confirmation Through Volume

Volume is a significant factor when considering the Dow Theory. Any trend should be confirmed by volume. For instance, during a bull run, volume should increase as the primary trend gains momentum and decrease during corrective phases. The opposite must be true when the market is in a bear run. Volume can also be used to determine confirmations, divergence, breakouts, reversals, resistance and support and more. 

Volume movement can be used as a barometer to confirm the strength and sustainability of the prevailing trend. 

• Reliance on Clear Trend Reversal Signals

According to this principle, traders and investors must assume a trend to be in place unless clear and compelling evidence of a reversal emerges. The Dow Theory emphasises identifying important indicators and signals to confirm a reversal to aid investors and traders in planning their strategies. 

How Can Traders Use the Dow Theory To Make Informed Decisions?

We have studied all the basic tenets of the Dow Theory, but how do we implement this in real-time markets? Let’s see

The Dow Theory largely rests on analysing trendlines, troughs and peaks, support and resistance, and other market patterns and formations. In conjecture with candlesticks, Dow Theory can help traders identify and confirm trends, and pick near-accurate entry and exit points and stop losses.  

Let’s read through some patterns to understand the application of Dow Theory in analysing stock charts. 

• Double and Triple Bottom

A double bottom typically signifies trend reversals. It will resemble the letter ‘W’, indicating a reversal after a downtrend. Assume a stock X is in a downtrend, hitting ₹40, then rising to ₹55, again falling to ₹40, and finally rallying to ₹70. A double bottom hints at a bullish reversal, marking a good entry point for traders. 

A triple bottom is nearly a replica of a double top, except that the price hits the bottom a third time. The more a stock price hits a certain price level, the stronger the trend is. In other words, the formation of a triple bottom is more strong of an indicator than a double top.  

• Double and Triple Top 

Just like a double bottom, the double top also hints at a trend reversal. This formation will resemble the letter ‘M’, indicating a reversal after an uptrend. Let’s again assume stock X is in uptrend, rising to ₹50, then falling to ₹40, rising again to ₹55, and finally falling to ₹30. This formation can hint toward exiting a stock in short-term trading. 

Like the double and triple bottom, the formation of a triple top is a stronger indicator than a double top. 

• Pattern Confirmation

Once a pattern is identified, say a double top or bottom, it is important that it is confirmed by the markets. Traders can use tools and technical indicators (moving averages, volume, MACD, ADX etc) to further confirm a trend. For instance, assume stock X has depicted a double bottom. Now, traders should make a move only once the resistance level is conveniently breached with substantial volume. 

• Range

A range is formed when a share’s price oscillates between a well-defined resistance and a support level. It typically signifies a period of indecision in the market when neither buyers nor sellers have a distinct advantage.  

Imagine a stock moving in the range of ₹50 to ₹100. The share price may touch the resistance and support levels multiple times for an extended period. This may also be defined as the sideway movement and does provide traders with multiple buy and sell opportunities.  

Traders may often look for a breakout or breakdown from this range to identify new potential trends (it can also lead to the formation of new resistance and support levels).  Stocks can break their range due to many fundamental factors, but it is essential to identify if it's a true breakout. 

A temporary breach accompanied by low volumes is the typical characteristic of a false breakout. A true breakout, more often than not, is accompanied by high volumes and substantial price rises. 

• Entry and Exit Points

Through the application of Dow Theory and the parameters mentioned above, traders can identify entry and exit points. For instance, assume share X has formed a triple bottom and is about to break its resistance level or the upper band of the range. Here, the trader can enter the stock, i.e. find an entry point and go long on the stock. The trader can also study other technical factors and a set stop loss for risk management.

Significance of the Dow Theory

Developed over a century ago, the Dow Theory carries great historical significance and relevance, even today. The theory has served as the foundational concept for technical analysis and forms the basis for many other technical tools and indicators. Traders have long used Dow Theory with other tools and concepts such as moving averages, trendlines, volume analysis and more to gauge a more comprehensive view of the market. 

But this alone is not why this theory enjoys popularity amongst all investor classes, whether novice or seasoned. 

• Easy to understand and interpret: The Dow Theory rests on some basic principles of the market, which are easy to understand and implement. 
• Reliance on long-term trends: Dow Theory has always emphasised long-term market trends and analysis, which is often stable and reliable. This simplifies the decision-making process for traders and investors as they are not overwhelmed by market noise or short-term fluctuations. For instance, a trader can analyse a certain long-term stock price chart and study the series of, say, different highs and lows (higher highs and higher lows or lower lows and lower highs) to determine the prevailing direction of the market. 
• Dependence on volume and sectors: The emphasis of the Dow Theory to systematically approach, identify and confirm market trends through volume is another feature in its cap and can help traders align their positions with broader market sentiments and potentially capitalise on profitable opportunities. 

It must also be remembered that Dow Theory heavily relies on monitoring the performance of industrial and transportation sectors, and this inclusion of sector analysis adds an extra layer of reliability and reduces the chances of false indications. 

• Early signals of trends: Dow Theory can also provide traders with early warning signals for recognising trend reversals. If, say, secondary trends take control over the markets against primary trends, traders can adjust their strategies accordingly, thereby protecting their capital and minimising losses. 

Limitations of the Dow Theory

While the Dow theory has evolved as a cornerstone in technical analysis, it is not devoid of limitations. 

• Focus on price movements: Dow Theory focuses on price movements, ignoring other critical factors such as market behaviour, industry trends and mood, fundamentals, macroeconomic indicators, etc. This myopic perspective may limit the understanding of the market as a whole. Many critics also state that this theory overlooks important quantitative factors and financial ratios that directly impact stock movements.

• Reliance on the closing price: The Dow Theory primarily rests on the analysis of the closing prices of stocks. It ignores intraday movements of the stock and indices. This limits the scope of the theory and can create a slippery slope for investors. 
• Over-reliance on historical data: The theory’s reliance on past price data may not account for sudden and sharp market shifts and changes that unforeseen events may trigger. For instance, take the Covid-19 pandemic, which caused severe market disruptions. Typical market trends and patterns observed by Dow Theory were overturned completely and defied its reliability in such situations. 
• Subjectivity: Different analysts may view or understand markets differently. This lack of consensus can create confusion amongst investors and traders and hinder the effectiveness of this theory. 
• Delay due to lagging indicators: Due to the inherent delay in the indicators/tools employed by this theory, many market participants may find themselves ill-equipped to respond swiftly to dynamic market changes. For example, by the time the trend is confirmed, a portion of the trend might have taken place. This can lead to inaccurate entry and exit points. 

In other words, this theory’s excessive reliance on lagging indicators may render it less effective in predicting real-time market movements. 

• Reliance on the price-weighted index:

The Dow Jones Industrial Average (DJIA), a key component of this theory, is price-weighted rather than market-weighted and is composed only of 30 large-cap stocks. This implies that individual stock prices are used to determine index value rather than the total market capitalisation of the companies. 

Let’s understand this quickly with an example. Assume three companies, A, B & C, listed on the DJIA, have their stock prices as $1000, $500, and $300, respectively. Now, because company A has a higher stock price, it will have a higher impact on the index. Now imagine what happens when company A’s stock prices rise exponentially or crash or undergo a stock split. The index would be heavily impacted. It wouldn't matter if company B or C had a higher market capitalisation than company A. 

Now you see, how this could be a problem for investors and traders.

• Composition of DJIA:

The DJIA index and its small sample size (of 30 stocks) may not be an ideal representation of the entire market and mood, especially considering the diversity of industries and sectors within the equities market. The overall consideration drawn here could, well, lead to skewed results. 

And with this, we conclude the chapter on Dow Theory. In the next chapter, we explore the nuances of another theory called the Elliott Wave Theory. We’ll be exploring the basis of this theory and how the modern markets interpret it.