Dow Theory for Investors

Dow Theory is an investment analysis tool, used to try and predict future stock price trends. Like all such tools, it cannot give 100% accurate predictions. However, it can help the stock trader to improve returns.

In 1897, and American investor, Charles Dow, compiled 2 market sector averages, in order to give indications of how the wider market was behaving. The first of these looked at the prices of 12 of the biggest blue-stocks, and compiled these prices into an Industrial Average. The second looked only at 20 railroad companies - giving the Rail Average. The 2 averages are now called the Dow Jones Industrial Average and the Dow Jones Transportation Average.

When Charles Dow looked at historical plots of these averages, trends could be perceived. He believed these trends could be used as an indicator for general business conditions.  So, between 1900 and 1902, he published a series of articles in The Wall Street Journal which then became known as the Dow Theory.

Like all theories, the Dow Theory is based upon assumptions. If you feel these assumptions are false, then you will probably not want to use this as market indicator. These assumptions are:

1. Market averages discount all news
   
2. There are 3 market trends
3. Primary Trends have 3 trend types
4. Averages will confirm each other
5. A trend is confirmed by trade volume
6. Only definite signals will confirm an end of a trend

This is the first assumption of the Dow Theory, and perhaps one of the most fundamental to the average investor.. It assumes that a stocks price reflects all that is known about the company (it can also be assumed for all securities). As I'm sure you can imagine, there are countless analysts sifting through news and reports all the time. When news about a company emerges, the stock price will adjust accordingly, as these analysts either buy or sell. These shifts in price will affect various market averages, and so these averages will indicate all that is known about the market at that time.

For the casual investor this assumption is important. Unless you have access to, and the time to digest, all company news, you can only judge trading conditions by how a market is rising / falling over a period of time. It is probably a sad fact that such an investor can only react after the news has affected share price.

At any given time, Dow Theory suggests there are only 3 trends within a stock price. Primary, secondary and minor trends.

Primary Trends

A primary market trend is the long term trend of the market. Long term means more than 1 year, and possibly many years. This trend is referred to as a bull market if it is rising, and a bear market if falling. A rising market is characterized by successive higher highs and lows. Whilst a falling market has lower highs and lows.

Secondary Trends

There are shorter trends within a market as well, some lasting for a few months. These are called Secondary Trends. These shorter trends will tend to support or detract from the primary trend, resulting in highs and lows over a few months. However, the secondary trend will not be so great as to over power the primary trend - if it's a bear market, the price should still continue up.

Minor Trends

Minor trends have the shortest affects on the price. They can last anywhere from a day to a week or two. These trends can result from large trades or just market 'jitters'. Dow Theory says that these minor trends can be misleading and so should be ignored.

Dow Theory recognizes that that investors have access to different information. For example, informed investors may believe an economic recovery will happen soon. These investors will buy stock whilst prices remain low. The general belief of market 'gloom' may remain, so prices may not increase significantly.

The second type of trend is when companies report increased earnings and improved trading conditions. Investor confidence will start growing, and so start buying stocks. As the number of investors buying stocks increases, the affect on stock price will be more apparent.

The final primary type is when the much wider public start to invest. This can be when companies report record profits and there is a general 'feel good' factor. As more buy, the price increases resulting in a buying frenzy. However, it is during this period that those who bought during the first trend will sell stock and lock profits in. This final trend never lasts as there will be a market correction at some point.

Market averages may be influenced by many different forces. The average of one sector can be driven up or down by localized news. Dow Theory states that averages from more than one market index will confirm a trend.

The start of a primary trend is the ideal time to invest, but it also the most difficult to identify. Many false indicators can be seen if the investor relies on only one market average. Therefor the investor should use at least 2 averages (Dow originally used the 2 average discussed above) to confirm a trend.

Although the price is the most important aspect of Dow Theory, the trade volume is also used to confirm a primary trend. As the price increases, Dow Theory assumes an increasing volume of trades with increase price. As a price decreases, the volume should also increase with the declining price.

The effects of the secondary trend will make it difficult to identify the end of a primary trend. As explained above, the secondary will have it's own highs and lows. With each low, it can be easy to believe the primary trend has changed. Acting on such false indicators may result in loss of profit from holding stock for longer.

Dow Theory states that a change in the primary trend is only real when there is a least one lower high and one lower low for a bull market and reverse for a bear market. Whilst not infallible, using this final assumption should allow the investor to judge the earliest change in a primary trend.

Use of Dow Theory

Dow Theory was ignored for a long time, as it doesn't perform as well as other indicators. However, it has become more popular recently, as it can improve the 'risk' element of investments, and so can be useful to the average investor.

Remember, you can lose a lot of money on the stock market and you do so at your own risk.