This post is part of our series: Modern Dow Theory – Part 1B
“The Dow Theory is the granddaddy of all technical market studies. Although it is frequently criticized for being “too late,” and occasionally derided (particularly in the early stages of a Bear Market) by those who rebel at accepting its verdicts, it is known by name to nearly everyone who has had any association with the stock market, and respected by most. Many who heed it in greater or lesser degree in determining their investment policies never realize that it is purely and simply “technical.” It is built upon and concerned with nothing but the action of the stock market itself (as expressed in certain “averages”), deriving nothing from the business statistics on which the fundamentalists depend.”
- Robert D. Edwards & John Magee, Technical Analysis of Stock Trends, 9th ed., Chapter Three; The Dow Theory
In the previous blog update, we talked about the broad overview and Dow Theory’s beginnings. In this posting, we will ride through the history and the backstory that made this indicator famous, and how they are connected to modern Technical Analysis today.
Dow Theory is one of the First Four Principles of Technical Analysis. It is number 4 on our list of the First Principles of Technical Analysis. It deals in what the market as a whole is telling you, and what are the strongest and weakest averages. Dow Theory indicates to the technician the overall market trend, and therefore dictates the types of positions that are the most likely to succeed, as well as signals when the positions should be managed for risk. The concept behind it includes the element of time and trend: that as time passes, company stock will tend to decline when all financial markets decline, and the same stock will tend to rise when markets rise. Charles Dow originally noted that the stocks of the market move together like schools of fish, and this is why his theory can be so valuable. Additionally, it is helpful to understand the strongest and weakest sectors of the market, as the stocks that make up a sector also generally move together. Dow Theory was originally created simply as a “barometer” of market conditions, as they revealed themselves in the averages; it was not initially designed as a predictor of market movement.* As mentioned in the opening quotation, Dow Theory is purely technical; it requires an examination of the flow of the broad market exclusive of other indicators. As stocks move together like fish, the market as a whole can be thought of as the ocean that contains these fish, and both our ocean and financial markets have their own ebbs and flows.
Dow originally explained his thoughts on the market in the editorials he wrote for The Wall Street Journal. His collected editorials were taken up and published by his successor, and in 1902 William P. Hamilton organized and outlined more than 25 years of market commentary into what is today known as “Dow Theory.” Continuing the aquatic” market theme, Dow Theory conveys further analogies such as the use of waves, major, secondary, and minor trends, peaks/troughs (as of waves), market movements that are described as tides that rise and fall, the raising/lowering of all boats, and trends and cycles that consistently continue somewhat similar to the patterns of the ocean that are generally consistent over time.
The next posting will describe the importance of peak-and-trough analysis and the concepts of high and low “water marks.”
*To be clear, Dow Theory does not aim to predict markets. It’s purpose is to reveal the current trend.