If you invest your money, it’s essential to know how the stock market is doing. It’s like having a roadmap to make smart choices about where to put your money. The Dow Theory is one such roadmap, and it has six important principles. In this blog post, we’ll break down these principles to help you understand where the market might be headed. It’s like having a secret code to predict the future of your investments.
The Context
To know values is to know the meaning of the market — Charles Henry Dow
Psychology and the study of financial markets are closely related.
This is simply because market behavior is the result of the willful choices made by innumerable investors who invest their money for a variety of reasons. The fundamental human activities that set up reactions in the market have mostly not changed over time. According to a study on human behavior, 90 percent of people can be divided into four fundamental personality types that represent some common behaviors. Here is a breakdown of those personality characteristics along with their stock market analogs.
≡ Optimistic (Bulls)
≡ Pessimistic (Bears)
≡ Confiding (Value Hunters), and
≡ Envious (Copycats)
Over time, several financial experts have tried to interpret these behaviors through stock market theories. Read the recommended write-up on the Top 10 stock market theories. One such timeless masterwork that every wise investor should be familiar with is the Dow Theory. Dow Theory is nothing more than a thorough examination of market behavior.
This notion still holds true in the market today despite being more than a century old. For both traders and long-term investors throughout their investing life cycles, the Dow theory works like a charm.
Say Hello To Charles Henry Dow
Dubbed the father of modern technical analysis, Charles Henry Dow was an American journalist who co-founded Dow Jones & Company with Edward Jones and Charles Bergstresser. Dow also co-founded “The Wall Street Journal”, which has become one of the most respected financial publications in the world.
He created an index of a dozen leading stocks, mostly railroads, that eventually became the Dow-Jones Industrial (DJIA) Averages, the most popular and widely read of all stock measurements.
The Dow Theory is derived from 255 editorials written in The Wall Street Journal between 1900-1902.
There are a total of six tenets that examine the market pulse and prevailing business environment.
And so they develop in this way:
1. Market Discounts Everything
The first tenet explains that any external influence such as new government policies, political plays, consumer sentiment, earning announcements by corporations, variation in inflation, etc. is already reflected in the price of stocks and indices except for the information on unexpected events such as natural disasters.
This tenet is similar to the Efficient Market Hypothesis (EMH) which was later introduced by Samuelson and Fama in the year 1965.
Value Investors should not take impulsive decisions based on the news and tittle-tattles.
2. Market Has Three Trends
The second tenet asserts that the market oscillates within three trends that result from commonly prevailing investor sentiments.
≡ Primary Trend — It is the major trend that shows how the market progresses in the long term.
A primary trend can span many years.
≡ Secondary Trend — These are trends that work opposite to the primary trend and are said to be corrections.
For instance, even if the primary trend is moving upward, there would be bursts of a ‘secondary’ downward trend which can sometimes last for a few weeks or months.
≡ Minor Trends — These are the deviations as seen in the daily market movement daily.
Minor trends usually last less than 3 weeks and go against the secondary trend.
Value investors should not be bothered by minor trends since the fluctuations are a result of market news and rumors.
3. A Trend Has Three Phases
This precept of Dow theory states that there are three phases to a primary trend that is self-repeating like a time loop.
≡ Accumulation Phase — This phase occurs after a steep fall in the market over the previous 6 months.
This is typically a time when Investors lose hope of any uplift in prices. The accumulation phase occurs when there is a beginning of a primary upward or downward trend in a bullish or bearish market.
In this phase, domestic and foreign institutional investors (FIIs & DIIs) such as mutual funds, pension funds, and large banks – buy up substantial shares of a given stock. This bulk action and their average purchase price structures a base as the shares of stock are accumulated.
≡ Participation Phase — In this phase, the improvement in market conditions and positive sentiments drive more investors to purchase more stocks.
It is the longest phase with large price movements. This phase usually results in market peaks and bubbles.
≡ Distribution Phase — In this phase when multiple events start creating panic in the markets, the investors rush to sell their stocks anticipating a market decline.
In this phase, investors try to book profits and exit from stocks.
Deep value investing is effortless and more impactful during the distribution phase.
4. Indices Must Confirm Each Other
For starters, a stock market index, also known as a stock index is a collection of stocks. It serves as a statistical measure that amplifies and reflects broad changes that are taking place in the market.
For instance, the Nifty 50, Sensex in India, and S&P 500 and Nasdaq Composite in the U.S. As per this tenet of the Dow Theory, the market behaving bearish and bullish should not be ascertained by one, single index.
All the indices should indicate a similar pattern. For example, in the case of a bearish trend; the Nifty 50, Nifty mid-cap 150, and Nifty small-cap 100 should all move in a downward direction.
Any deviation in an individual index could very well be an isolated event resulting from speculative or corrective moves.
Any kind of trend-related judgements must be formulated after examining multiple indices in conjunction.
5. Volumes Should Confirm Trends
This tenet of Dow Theory states that an ongoing trend will be confirmed with its trading volume. A trading volume is the amount of a security or stocks that are traded during a given period.
If the trend is upward, the trading volume rises with a price increase and falls with a price decline. In a downward trend, the volume of trading should go down with a price decline.
6. Trend Should Continue Until Clear Reversals
This precept states that depending on the situation, one should keep on buying or selling their stocks in the ongoing trend unless there are clear signs of reversals given by technical tools and indicators.
You can learn more about technical analysis in our curated course. Here, the reversal is when the orientation of a price trend has changed, from going up to going down, or vice-versa.
Conclusion
The Dow theory is regarded as a technical analysis concept that is mainly applied by traders. This principle applies equally well to value investors. While fundamental analysis offers the fundamental components of a long-term portfolio, a solid technical understanding aids in scaling up.
This hypothesis also has certain paradoxical limits, which is consistent with the overall idea of the majority of trend studies. The Dow Theory’s main flaw is that trends are lagging indications that it depends on. The major trend would already be established by the time a pattern like a primary trend is validated, and the investor might lose some of that move. This concludes the six tenets celebrated in Dow’s theory.
We’d love to know what you think about Dow’s theory in the comments below.
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1 Comment
Great refresher