Dow Theory is an old but useful method for analyzing stock market trends through proof and confirmation. By applying the Dow Theory, investors can recognize primary trends and identify the six phases of a complete stock market cycle.
Dow Theory was created by Charles H. Dow (1851–1902), an American journalist and co-founder of Dow Jones and Company. After Charles Dow's death, William Peter Hamilton, Robert Rhea, and E. George Schaefer expressed Dow’s editorial as an integrated theory and gave birth to the Dow Theory.
Introduction to the Dow Theory
Although the theory was developed to analyze stock market trends exclusively, it can be applied to many other financial markets. What is particularly interesting, is the Dow Theory analysis of the six market phases of a full market cycle.
Starting with the basic principles of the theory.
Basic Principles of the Dow Theory
According to Charles Dow, the stock market is a reliable indicator of the general business condition. These are the basic principles behind the Dow Theory:
- Stock market prices discount everything, including all news (What is often called the “Efficient Market Hypothesis”)
- Only closing prices matter (Dow Theory considers intraday highs and lows as market noise and completely irrelevant to market analysis)
- There are 3 different types of market trends (Primary, Secondary, and Minor trends -As they are briefly explained below)
- Each primary bullish or bearish trend includes 3 different phases (Each phase is briefly explained below)
- For a stock market trend to be legit, the Dow Jones Industrial and the Dow Jones Transportation must confirm each other
- A primary trend should be assumed to continue until its reversal has been definitely signaled (The theory advocates caution not to confuse primary trends with secondary trends)
- Volume should harmonically go with the trend, and generally increase if the price follows the direction of the primary trend, and decrease if the price moves against it
Note that Wyckoff also argued that if price and volume are found in perfect harmony, there is an already established price trend and a high probability that this trend will continue.
3 Different Types of Market Trends (3 Forces of the Dow Theory)
According to the Dow Theory, three main forces are determining the nature of every market movement:
(i) Primary or Master Trends
A Primary or Master Trend reflects the long-term trend of the market and may last from one year to several years. Bullish primary trends usually last for 7-9 years, while bearish primary trends usually last 1-2 years.
(ii) Secondary Reactions or Medium-Swings
A Secondary Reaction refers to a market movement against its primary direction. During a Secondary Reaction, the stock market may retrace from 1/3 to 2/3 of the primary price change since the previous secondary reaction. These ‘reactions’ usually last a couple of weeks to three months.
(a) During bear markets, secondary reactions are called ‘bear-market rallies’
(b) During bull markets, secondary reactions are called ‘bull-market corrections’
(iii) Minor Trends
Minor trends refer to speculative short-term market movements. A Minor Trend lasts from a single day to a couple of weeks (rarely more than 6 days) and is the only type of trend that can be manipulated. Note, that a secondary move may include a series of three or more minor trends.
Explaining Stock Market Trends and Phases
Dow Theory argues that market cycles follow a specific structure including 6 phases. A full market cycle commences with 3 bullish phases and continues with 3 bearish phases. A bullish trend is formed by a series of higher peaks and troughs and a bearish trend by a series of lower peaks and troughs.
Keep in mind, that this model is similar to the Elliott Wave theory, however, there is a key difference. Dow Theory counts six phases while Elliott only counts five phases.
Chart: The 6 Phases of the Dow Theory
Keep that six-wave chart in your mind, because you are going to use it frequently during 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 bad and the public is generally bearish. However, institutional investors start buying the market by spotting stocks that are considerably undervalued. Let’s call these expert investors the ‘smart money’. Smart money buys against the general market sentiment and tries to do it without being spotted by retail traders and the media. Stock market prices accumulate as the demand from smart money equals the supply from retail investors. During this accumulation phase, the market ranges between a major support and a major resistance level with low volume.
-This phase corresponds to Wyckoff’s Accumulation phase (more about Wyckoff’s model)
-This phase can also be considered as similar to the Elliott’s first wave (more about Elliott’s model)
(ii) Public Participation (Bullish Phase-2)
During this second phase, business conditions and corporate earnings are now improving. The demand deriving from ‘smart money’ starts to peak, and consequently, retail investors and the media eventually realize that something is going on. As more investors buy the market, a strong trend is now formed. Market prices cross above the previous range and volume starts to boom. Short-term speculators have also joined the rally, something that is usually reflected in metrics such as ‘open interest’ and COT reports. This phase will continue until the majority of short-term speculators decide to capitalize on their profits. As most speculators simultaneously close their positions, the market corrects leading to the next phase.
-During this phase-2, you are going to see a bullish MACD cross on the weekly or even the monthly chart, while the daily RSI (D1) will probably 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 good and stock market prices rapidly advance. Everybody has joined the rally, and retail greed is pushing the market even higher while the volume is booming. However, the market is becoming fundamentally expensive (in terms of P/Es, P/Bvs, etc.), therefore, smart money starts to capitalize on its profits.
-During this phase-3, you are probably going to see a weekly or even a monthly RSI close to 80
(iv) The Distribution Phase (Bearish Phase-1)
During this phase, the business conditions are still good, but the market is now expensive. This is the initial phase of the new bear market and the exact opposite phase of the accumulation phase-1 of the bull market. Smart money now aggressively sells its holdings. However, prices don’t tank as most retail investors remain buyers. During the first few days of phase-1, the volume booms while the media advises retail investors to hold their positions as better days are coming for the stock market.
-Near the top, the weekly and/or the monthly RSI will probably peak above 80
-This phase corresponds to Wyckoff’s Distribution phase (more about Wyckoff’s model)
-This phase can also be considered as similar to the Elliott’s initial bearish wave (more about Elliott’s model)
(v) Public Participation (Bearish Phase-2)
Business conditions are now getting worse and retail investors realize that the rally is probably over. They now want to sell the market. Smart money continues to sell, and prices are falling fast. However, panic is not yet seen, as retail investors anticipate that they will have a better opportunity to sell their positions. Volume activity starts to shrink as there are many sellers and only a few buyers (mainly retail speculators).
-In this phase, you are probably going to 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 last phase, business conditions and financial reports are getting very bad. Phase-3 of the bear market is characterized by pure panic. Everyone wants to exit the market at any price triggering a general sell-off. The media reports are calling for a dying stock market. However, during this phase, smart money does not sell anymore. On the contrary, smart money buys selectively assets that are fundamentally undervalued. In the 18th century, Baron Rothschild said: “Buy When There's Blood in The Streets.”
-During this phase-3, you are probably going to see a monthly RSI close to 20
The Dow Averages Mechanism -Comparing Dow Industrial and Dow Transportation
To spot changes in the primary market trends, the Dow Theory uses two basic stock-market averages: the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA).
According to the Dow Theory, if one of its major averages (DJIA or DJTA) advances above a level of historical significance, and at the same time, the other average advances as well, then the market is in a well-established bullish trend. On the contrary, if one of the DJIA or DJTA averages declines below a level of historical significance, and at the same time, the other average declines as well, then the market is in a well-established bearish trend.
(a) If the master trend of both DJIA and DJTA changes, then the master trend of the whole market is considered as changed
(b) If the master trend of only one of these two averages changes, then this is considered a secondary trend
Chart: Dow Industrial (^DJIA) compared to Dow Transportation (^DJT)
In the above chart, there are two occasions (spotted as A and B) where significant divergences exist between the performance of the two Dow averages. These divergences can be seen as market disharmonies.
Conclusions -Why Dow Theory is Still Important to This Day
Dow theory can be seen as the first complete follow-the-trend trading strategy in the world. Additionally, it was the first theory to offer investors specific conditions for entering and exiting the market. Although it was introduced more than 100 years ago, the Dow Theory applies to this day, let’s see why it is still important:
- Dow theory combines different aspects of technical analysis with business conditions and market psychology to create a complete framework for analyzing stock market trends and their phases
- Dow Theory seeks to recognize the fundamental structure behind a full market cycle, something very useful for the analysis of every financial market, not only equities. The recognition of a fundamental market structure leads to the implementation of a rational framework of analysis without the hazards of fragile human psychology
- Dow theory constantly seeks proof and confirmation, a very valuable notion to a modern world suffering from fake news and hype
- Dow Theory is useful for recognizing the nature of each market trend, and then focusing on primary trends lasting for years, rather than on secondary trends that are temporary and irrelevant for long-term investors
- Dow theory focuses on the recognition of the current phase of the market. Being able to identify the current phase of the market is the most important thing in investing. By identifying the phase of the market, you know where and when you should invest
- Dow theory can be seen as a contrarian theory, as it aims to evaluate the market against the public beliefs. For example, it suggests buying the market as the primary trend reverses bullish, at the early stages of the bull market when the public is in fear. Then to stay in the market until the trend is confirmed to reverse bearish, by again being contrarian to the public, which this time is greedy
- The 6-wave chart of the Dow Theory applies to every financial market in the world with public participation, not only to equities
- The Dow theory is compatible with other dominant market theories such as Elliott Waves and Wyckoff’ 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
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