Dow Theory is an old but effective method for analyzing stock market trends through observation and confirmation. Using Dow Theory, investors can identify primary trends and the six phases of a full market cycle.

Dow Theory was developed by Charles H. Dow (1851–1902), an American journalist and co-founder of Dow Jones & Company. After Dow’s death, William Peter Hamilton, Robert Rhea, and E. George Schaefer expanded his editorials into a complete theory, which became known as Dow Theory.

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Introduction to the Dow Theory

Although the theory was originally developed to analyze stock market trends, it can be applied to many other financial markets. What is particularly interesting is Dow Theory’s analysis of the six phases of a full market cycle.

Starting with the basic principles of the Dow Theory.

 

 

Basic Principles of the Dow Theory

According to Charles Dow, the stock market is a reliable indicator of the overall business condition. These are the basic principles of Dow Theory:

• Stock market prices reflect everything, including all news (often called the “Efficient Market Hypothesis”).

• Only closing prices matter (Dow Theory treats intraday highs and lows as market noise, irrelevant for analysis).

• There are three types of market trends: Primary, Secondary, and Minor (briefly explained below).

• Each primary bullish or bearish trend has three phases (briefly explained below).

• For a market trend to be valid, the Dow Jones Industrial and Dow Jones Transportation indexes must confirm each other.

• A primary trend should be assumed to continue until a definite reversal signal appears (the theory warns not to confuse primary trends with secondary trends).

• Volume should move in harmony with the trend, generally increasing if prices follow the primary trend and decreasing if prices move against it. 

👉 Note: Richard Wyckoff also argued that when price and volume are perfectly in harmony, a price trend is already established, and there is a high probability it will continue.

 

3 Different Types of Market Trends (3 Forces of the Dow Theory)

According to Dow Theory, three main forces determine the nature of every market movement:

1️⃣ Primary or Master Trends

A Primary or Master Trend reflects the market’s long-term direction and can last from one year to several years. Bullish primary trends usually last 7–9 years, while bearish primary trends typically last 1–2 years.

2️⃣ Secondary Reactions or Medium Swings

A Secondary Reaction is a market movement against the primary trend. During a Secondary Reaction, the market may retrace 1/3 to 2/3 of the primary price change since the previous secondary reaction. These reactions usually last a few weeks to three months.

(a) In bear markets, secondary reactions are called “bear-market rallies.”

(b) In bull markets, secondary reactions are called “bull-market corrections.”

3️⃣ Minor Trends

Minor Trends are short-term, speculative market movements. They usually last from a single day to a couple of weeks (rarely more than six days) and are the only type of trend that can be manipulated. A secondary move may include a series of three or more minor trends.

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Explaining Stock Market Trends and Phases

Dow Theory states that market cycles follow a specific structure with six phases. A full market cycle begins with three bullish phases and is followed by three bearish phases. A bullish trend is characterized by a series of higher peaks and troughs, while a bearish trend shows a series of lower peaks and troughs.

Note that this model is similar to Elliott Wave theory, but with one key difference: Dow Theory identifies six phases, while Elliott counts only five.

Chart: The 6 Phases of the Dow Theory

👉 Keep that six-wave chart in mind, as you will refer to it often throughout your investing career.

Let’s try to explain the six phases of a full stock market cycle (author’s view). The market cycle starts with the accumulation period.

(i) Accumulation (Bullish Phase-1)

During this first phase, business conditions and financial reports are weak, and the public is generally bearish. However, institutional investors begin buying by identifying significantly undervalued stocks. Let’s call these expert investors the “smart money.” Smart money buys against the general market sentiment, trying to do so without attracting attention from retail traders or the media. Stock prices gradually rise as demand from smart money balances supply from retail investors. During this accumulation phase, the market moves between a major support and resistance level with low volume.

-This phase corresponds to Wyckoff’s Accumulation phase 🔗 Read More: » Wyckoff’s model

-This phase can also be considered as similar to Elliott’s first wave 🔗 Read More: » Elliott’s model

(ii) Public Participation (Bullish Phase-2)

During this second phase, business conditions and corporate earnings are improving. Demand from the “smart money” begins to peak, and eventually, retail investors and the media notice the activity. As more investors enter the market, a strong trend forms. Prices break above the previous range, and volume increases significantly. Short-term speculators also join the rally, often reflected in metrics like open interest and the Commitments of Traders (CFTC) reports. This phase continues until most short-term speculators take profits. When many speculators close their positions at once, the market corrects, leading to the next phase.

-During this phase, you may see a bullish MACD cross on the weekly or even monthly chart, while the daily RSI (D1) will likely peak above 80.

-Generally, public participation is the longest phase of the bull market

(iii) Excess Phase of the Bull Market (Bullish Phase-3)

During this phase, all financial news is positive, and stock prices rise rapidly. Everyone has joined the rally, and retail greed pushes the market even higher while volume soars. However, the market is becoming fundamentally overvalued (in terms of P/E, P/B ratios, etc.), so smart money begins taking profits.

-During this phase 3, you may see a weekly or even a monthly RSI close to 80

(iv) The Distribution Phase (Bearish Phase-1)

During this phase, business conditions are still strong, but the market is now overvalued. This marks the beginning of a new bear market and is the opposite of the accumulation phase of the bull market. Smart money begins selling its holdings aggressively. However, prices don’t crash because most retail investors continue buying. In the first few days of this phase, volume spikes while the media advises retail investors to hold, suggesting better days are ahead for the market.

-Near the top, the weekly and/or the monthly RSI will probably peak above 80

-This phase corresponds to Wyckoff’s Distribution phase

-This phase can also be considered similar to Elliott’s initial bearish wave

(v) Public Participation (Bearish Phase-2)

Business conditions are worsening, and retail investors realize the rally is likely over. They start selling. Smart money continues to sell, and prices drop quickly. Panic hasn’t set in yet, as retail investors expect a better opportunity to sell later. Volume begins to shrink, with many sellers and only a few buyers, mostly retail speculators.

-In this phase, you may see a bearish MACD cross on the weekly or even the monthly chart

-Generally, public participation is the longest phase of the bear market

(vi) The Panic Phase (Bearish Phase-3)

In this final phase, business conditions and financial reports are very poor. Phase 3 of the bear market is marked by panic. Everyone wants to exit the market at any price, triggering a widespread sell-off. Media reports warn of a dying stock market. However, smart money stops selling and begins selectively buying fundamentally undervalued assets. As Baron Rothschild said in the 18th century: “Buy when there’s blood in the streets.”

-During this phase 3, you may see a monthly RSI close to 20

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The Dow Averages Mechanism -Comparing Dow Industrial and Dow Transportation

To identify changes in primary market trends, Dow Theory relies on two key stock-market averages: the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA).

According to Dow Theory, if one major average (DJIA or DJTA) rises above a level of historical significance and the other average rises as well, the market is in a confirmed bullish trend. Conversely, if one average falls below a significant historical level and the other falls too, the market is in a confirmed bearish trend.

(a) If the master trend of both DJIA and DJTA changes, the overall market’s master trend is considered to have changed.

(b) If only one of these averages changes its master trend, it is considered a secondary trend.

Chart: Dow Industrial (^DJIA) compared to Dow Transportation (^DJT)

👉 Note: In the chart above, there are two points (marked A and B) where significant divergences appear between the two Dow averages. These divergences can be seen as market disharmonies.

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Conclusions -Why Dow Theory Is Still Relevant Today

Dow Theory can be seen as the first complete follow-the-trend trading strategy in the world. It was also the first theory to give investors clear rules for entering and exiting the market. Although introduced over 100 years ago, Dow Theory remains relevant today. Here’s why:

• Dow Theory combines technical analysis, business conditions, and market psychology to create a comprehensive framework for analyzing stock market trends and their phases.

• It aims to identify the fundamental structure of a full market cycle, which is useful for analyzing all financial markets, not just equities. Recognizing this structure allows for rational analysis without being swayed by fragile human psychology.

• Dow Theory emphasizes proof and confirmation, a valuable approach in today’s world of fake news and hype.

• It helps investors recognize the nature of each market trend, focusing on long-term primary trends rather than temporary secondary trends that are irrelevant for long-term investing.

• Dow Theory highlights the importance of identifying the current phase of the market. Knowing the phase helps investors understand where and when to invest.

• The theory is contrarian, evaluating the market against public sentiment. For example, it recommends buying early in a bull market when the public is fearful and selling only when the trend reverses to bearish, even if the public is greedy.

• The six-wave chart of Dow Theory applies to all financial markets with public participation, not just equities.

• Dow Theory is compatible with other major market theories, such as Elliott Waves and Wyckoff’s Accumulation/Distribution.

 

■ Explaining the Dow Theory Trading Strategy

George Protonotarios, financial analyst

for TradingCenter.org (c) -31st January, 2025

 

 🔗 Sources:

• Book “Trading World Markets Using Phi and the Fibonacci Numbers” by G. Protonotarios
• Book “Technical analysis of stock trends” by Edwards and Magee