Dow Theory
From Free net encyclopedia
Dow theory is a theory on stock price movements that provides the basis for technical analysis. The theory originally derived from the editorials of Charles H. Dow (1851–1902), journalist, first editor of the Wall Street Journal and co-founder of Dow Jones and Company. It was refined after his death by William P. Hamilton, Charles Rhea and E. George Schaefer and collectively represented as "Dow Theory". Dow himself never used the term "Dow theory" though. It was Dow who first compiled a stock market average that he thought was representative of the US economy. This later grew into the stock market index that still bears his name: the Dow Jones Industrial Average.
Dow never wrote a book that summarized his beliefs, but his beliefs organized by the aforementioned are summarized below.
There is very little evidence that the Dow theory can be used to earn excess profits in the stock market. Alfred Cowles in a landmark study in Econometrica in 1934 showed that trading based upon the editorial advice of William Hamilton in the Wall Street Journal, would have resulted in earning less than a buy-and-hold strategy using a well diversified portfoilio. Neverthess, Brown, Goetzmann, and Kumar [1], using Cowles's data show that the returns of the two strategies were essentially identical, but that the "Dow" strategy was less risky and showed ability to time the market.
Contents |
Six beliefs
Markets have three trends
To start with, Dow defined an uptrend as a time when successive rallies in a security price close at levels higher than those achieved in previous rallies and when lows occur at levels higher than previous lows. Downtrends occur when markets make lower lows and lower highs. It is this concept of Dow Theory that provides the basis of technical analysis' definition of a price trend.
Dow described what he saw as a recurring theme in the market: that prices would move sharply in one direction, recede briefly in the opposite direction, and then continue in their original direction.
Trends have three phases
Dow Theory asserts that major market trends are composed of three phases: an accumulation phase, a public participation phase, and a distribution phase. The accumulation phase is when investors "in the know" are actively buying (selling) stock against the general opinion of the market. During this phase, the stock price does not change much because these investors are in the minority absorbing (releasing) stock that the market at large is supplying (demanding). Eventually, the market catches on to these astute investors and a rapid price change occurs. This is when trend followers and other technically oriented investors participate. This phase continues until rampant speculation occurs. At this point, the astute investors begin to distribute their holdings to the market.
The stock market discounts all news
Stock prices quickly incorporate new information as soon as it becomes available. Once news is released, stock prices will change to reflect this new information. On this point, Dow Theory agrees with one of the premises of the efficient market hypothesis.
Stock market averages must confirm each other
In Dow's time, the US was a growing industrial power. The US had population centers but factories were scattered throughout the country. Factories had to ship their goods to market, usually by rail. Dow's first stock averages were an index of industrial (manufacturing) companies and rail companies. To Dow, a bull market in industrials could not occur unless the railway average rallied as well, usually first. The logic is simple to follow. If manufacturers' profits are rising, it follows that they are producing more. If they produce more, then they have to ship more goods to consumers. Hence, if an investor is looking for signs of health in manufacturers, he or she should look at the performance of the companies that ship the output of them to market, the railroads. The two averages should be moving in the same direction. When the performance of the averages diverge, it is a warning that change is in the air.
Even today, both Barron's magazine and the Wall Street Journal publish the daily performance of the Dow Jones Transportation Index in chart form. The index contains all the major railroads, shipping companies, and air freight carriers in the US.
Trends are confirmed by volume
Dow believed that volume confirmed price trends. When prices move on low volume, there could be many different explanations why. An overly aggressive seller could be present for example. But when price movements are accompanied by high volume, Dow believed this represented the "true" market view. If many participants are active in a particular security, and the price moves significantly in one direction, Dow maintained that this was the direction in which the market anticipated continued movement. To him, it was a signal that a trend is developing.
Trends exist until definitive signals prove that they have ended
Dow believed that trends existed despite "market noise". Markets might temporarily move in the direction opposite the trend, but they will soon resume the prior move. The trend should be given the benefit of the doubt during these reversals. Determining whether a reversal is the start of a new trend or a temporary movement in the current trend is not easy. Dow theorists often disagree in this determination. Technical analysis tools attempt to clarify this but they can be interpreted differently by different investors.
References
- J. M. Hurst: The Profit Magic of Stock Transaction Timing. Englewood Cliffs, N.J.: Prentice-Hall, 1977. [ISBN 0137260008] (Analysis of the empirical character of US stock market movements prior to 1973) {NB: Also, [ISBN 0934380627]}
- John Murphy: Technical Analysis of Futures Markets. New York, N.Y.: New York Inst. of Finance, 1986. [ISBN 013898008X]