Charles Dow, the originator of Dow theory, never wrote a book on the theory. However, he wrote many articles which act as the basic building blocks of the Dow theory. These century-old concepts are still valid in the current market environment and are used by investors and traders in making their trading decisions. S.A. Nelson, William Hamilton, and Robert Rhea need to be credited for later refinements in the theory through their books named The ABC of Stock Speculation, The Stock Market Barometer, and The Dow Theory respectively. In fact, S.A. Nelson actually coined the term ‘Dow Theory’.
In the late nineteenth century, Dow published two industrial averages, consisting of lists of stocks, namely Industrial Index and Rail Index. He then applied the basic principles developed by him on these averages. Dow considered these averages as reliable indicators that reflected the overall health of the economy. Thus by analyzing the averages he assessed the most likely trends in the market. In this article, I have tried to throw some light upon the basic principles of Dow theory with the help of real-time charts and examples.
PRINCIPLES OF DOW THEORY
- The Averages Discount Everything
The Dow theory works on the premises of an efficient market, which states that the price reflects all available information. According to Dow the market’s, earnings potential, revenue projections, managerial competence, elections, any bad news, and other future events are all discounted into the market price itself. Any unexpected event such as natural calamities, etc. will affect the market in the short term but the primary trend will remain intact. In the following monthly chart, there are two sharp reaction lows, formed probably on some very bad news about the economy, but the market absorbed all the bad news and the primary trend resumed.
2. The Averages Must Confirm Each Other
In simple terms, this principle infers that if the Industrial Average index is signaling a new uptrend then it should be confirmed by a similar signal on the Rail Average index. If that does not happen and the two indices are showing divergence, then it would be incorrect to assume that the new trend has been initiated. He used a simple logic that is working behind this principle. He assumed that for any industrial activity to pick up, more metal will need to be transported which would be done through rails and hence the rail index will foretell the business activity that is going to pick up. Thus both the indices should move in line.
3. Three Trends of the Market
The theory identifies three types of trends in a market namely, Primary, Secondary, and Minor. An uptrend has been identified by the successive higher high formation and the downtrend by successive lower low formations. The primary trend of the market is simply the trend on larger timeframes. It could be up or down and last for about a year or more. Within a primary trend, there are secondary trends, which work against the primary trend ( refer to Nifty chart below)
On a smaller time frame, they will look like a downtrend but in reality, they are pullbacks that may retrace up to half of the previous up move. These trends last from three weeks to three months. Minor trends are the daily fluctuations that last from a few hours to few days but less than three weeks.
4. Three Phases of the Primary Trend
Dow theory focuses on the primary trend of the market and opines that this phase broadly comprises of three phases – Accumulation, Public Participation, and Distribution. The Accumulation phase would have a major downtrend in its background. All the news would be bad about the market and at this point, investors would look for value buying and hence start accumulation which is nothing but buying in phases at better bargains. It marks the beginning of the second phase that is, public participation. As the market comes out of accumulation the trend would be confirmed and this attracts technical trend-following traders into the market. The news about the economy will start improving during this phase. Buying by these smart technical traders would push the price to a point where the left-out retail traders would jump in and start buying.
At this point, the news would be all good and there will be bullish stories on the newspapers and televisions. This positive sentiment would lead to a very rapid push in the market and hence the beginning of the third phase, that is distribution. The investors who bought in the first phase would start selling which would stall the market and initiate a change in the primary trend. The historical weekly chart of Adani Ports (above) is a good representation of all three phases.
5. Importance of Volume in a Trend
Dow’s theory recognizes that volume is an important factor in the market but still, it gives secondary importance to volume. In most simple words, according to Dow, the volume should increase if the price is moving in the direction of the primary trend and decrease if it is moving against the primary trend. Such a volume trend is visible on the following daily chart of Reliance industries limited. Notice how volume increases in the direction of the primary trend and recedes against the primary trend. It confirmed that the primary trend was intact without any inherent weakness in it.
Low volume in the direction of the primary trend would signal weakness in the trend. Similarly, increasing volume against the primary trend would reflect weakness and signals shift in sentiment which would act as a precursor to change in trend.
6. Trend Reversal Signals
Reversals in primary trend are the most tedious task for Dow theory followers as well as for all trend following traders. Most of the time in a primary bull market it is difficult to determine whether the pullback is a secondary trend or it is actually the change in trend or reversal.
According to Dow, a combination of a lower high with a lower low and a higher high with a higher low would help in identifying a change in trend. A lower low without a lower high and a lower high without a lower low will not be considered a change in trend from bullish to bearish. This means there is a need to have a lower high before a lower low confirms the change in trend to bearish. Similarly, a higher high without a higher low and a higher low without a higher high would not be considered a change in trend from bearish to bullish. This means there is a need to have a higher low in place before a higher high confirms the change in trend to bullish (refer to the above daily chart of Nifty50). Notice at point A higher low is formed but it is not followed by a higher high and the wave stopped at point B followed by another low which was lower than A. So there was no change in the trend until a higher high is made after a higher low.
7. Importance of Closing Prices and Ranges
Charles Dow relied solely on closing prices and was not concerned about the price movements. In a primary bull phase, the market has to close higher than the previous high to confirm that the trend is still up. Similarly, in a bear market, it has to close lower than the previous trough to confirm that trend is still down. Thus the intraday price fluctuations would not be taken into consideration while looking for confirmations of trends.
In Dow theory Lines simply refer to the ranges or consolidations which usually represent sideways price action over a period of time. Normally they represent accumulation or distribution but these two scenarios would be confirmed only on the break of range. Thus the break of the trading range would decide the market direction. In order to confirm, horizontal lines are drawn at the top and the bottom of the range. If the breakout occurs on the upside and the market closes up, then the market will trend higher. Similarly, if it breaks down and closes lower, it will trend lower (refer above weekly chart of Adani Ports).
It is true that the trend confirmation mechanism of Dow theory is too late to fire signals. The market has to close higher than the previous high to confirm the continuation of a trend. In addition to a higher high, it has to form a higher low to confirm a change from a downtrend to an uptrend. Thus traders or investors might miss the first up move, before confirmation, which normally happens to be a strong price appreciation. But it needs to be pointed out here that Dow never tried to anticipate trends. He intended to recognize the primary trend and capture the major middle portion. Thus he focused on the identification and following the trend; rather than picking tops and bottoms. Although Dow’s theory is not infallible yet it helps investors and traders to understand the market structure and to develop their foundation for technical analysis.