What Is the Dow Theory?
The Dow Theory is one of the oldest forms of technical market analysis. Developed from a series of Wall Street Journal editorials by Charles H. Dow in the late 19th and early 20th centuries, it holds that broad market averages reflect underlying business conditions and that careful study of those averages reveals the market’s primary direction. Dow’s observations were later expanded by followers and formed the core principles many modern technicians still use: trend identification, confirmation across indices, and the role of volume and price structure.
Key goals
– Determine whether the market is in a primary uptrend (bull market), a primary downtrend (bear market), or neither.
– Enter and remain positioned with the primary trend, exiting when a confirmed reversal occurs.
Origins and evolution
– Originator: Charles H. Dow, cofounder of Dow Jones & Company and the Wall Street Journal.
– Early tools: the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA). Dow assumed that if industry profits were rising, transport companies (originally railroads) would also show rising performance; both averages should therefore agree on the market’s direction.
– Evolution: Followers codified Dow’s editorials into a formal set of principles. Over time the specific indices used and the transport/industry relationship have been reinterpreted for modern markets, but the conceptual framework remains widely taught and applied.
The six central tenets of Dow Theory
1. The market discounts everything
– All known information (earnings, macro events, sentiment, expectations) is expected to be reflected in prices. In strict interpretation, even expected future events are priced in as risk assessments.
2. There are three kinds of trends
– Primary trends: long-term (often months to years), the dominant bull or bear markets.
– Secondary trends: intermediate corrections or countertrends (weeks to months) that partially retrace the primary trend (commonly ~33%–66% retracements).
– Minor trends: short-term fluctuations (days to weeks), considered market “noise.”
3. Primary trends have three phases
Bull market phases:
– Accumulation: informed investors buy; prices move sideways or slightly up.
– Public participation: broader buying drives clear sustained price advances.
– Distribution: informed investors sell into the strength; advance slows.
Bear market phases (mirror structure, with common labels):
– Distribution: early selling by informed holders.
– Panic/decline (public participation to downside): broad selling accelerates.
– Stabilization/accumulation: price reaches base, eventually attracting buyers.
4. Indices must confirm each other
– A valid primary trend signal (e.g., new highs) on one average should be confirmed by similar movement in another relevant average. Dow used the Industrial and Transportation averages; modern practitioners may use DJIA and DJTA, S&P 500 and a transport or small-cap index, or a broad market index and a related sector index.
5. Volume must confirm the trend
– Volume should expand in the direction of the primary trend (rising volume on advances in a bull market; rising volume on declines in a bear market). Weak volume during trend moves signals potential fragility.
6. Trends persist until a clear reversal occurs
– The trend remains in force until there is convincing evidence of a change—usually through failure to make successive highs/lows and confirmation from other averages and volume.
The role of closing prices and line ranges
– Closing prices: Dow emphasized closing prices over intraday moves when judging trends because closes summarize the day’s consensus. Many Dow-theory followers today still use daily closes to identify peaks and troughs.
– Line ranges (trading/consolidation ranges): Periods of sideways price action represent consolidation. Dow advised waiting for a decisive breakout above or below the range before concluding that a new directional leg has started.
Identifying trends and signals (practical rules)
– Peak-and-trough analysis:
– Uptrend: successive higher peaks (highs) and higher troughs (lows).
– Downtrend: successive lower peaks and lower troughs.
– Confirming a new primary trend:
1. Chart the primary index with daily closes and mark peaks/troughs over months.
2. Determine if a new primary high (for uptrend) or low (for downtrend) has been formed.
3. Check a second index for confirmation (e.g., transportation vs. industrial). Both should show equivalent directional evidence.
4. Verify volume: volume should increase on the confirming move.
5. If all three align (price structure, index confirmation, rising confirming volume), treat the signal as valid. Otherwise, be cautious.
Reversals: how to spot and avoid false signals
– A reversal is more likely when:
– The pattern of higher highs/higher lows (or lower lows/lower highs) breaks down for an extended period.
– The second index fails to confirm the move.
– Volume behaviors contradict price (e.g., rising prices on falling volume).
– Because primary reversals can take months to form, short-term counter swings often look like reversals but are secondary trends. Dow Theory emphasizes waiting for confirmation to avoid whipsaws.
What are the three trends of Dow Theory?
– Primary (months to years) — the dominant bull or bear market.
– Secondary (weeks to months) — corrections or countertrend moves inside the primary trend.
– Minor (days to weeks) — short-term noise and intraday swings.
What is the goal of Dow Theory?
– To identify the primary market trend and trade (or position asset allocations) in the direction of that trend, exiting when a confirmed reversal occurs.
What factors affect the Dow?
– The Dow averages reflect many inputs that can move prices: corporate earnings expectations, interest rates, macroeconomic data (GDP, employment), geopolitical events, sector rotations, and investor sentiment. Dow Theory assumes much of this information is already incorporated into price, but major new information can change the trend.
Practical step-by-step guide to applying Dow Theory (for traders and investors)
1. Choose your paired averages/indices
– Classic pair: DJIA and DJTA. Modern alternatives: S&P 500 + a broad transport index, or sector pairs that represent economic activity and its enablers (choose indices you can reasonably expect to move together if the economy is changing).
2. Use daily closing data and a suitable long-term chart
– For primary trend assessment, use weekly and daily charts with several months to years of history. Mark the major peaks and troughs.
3. Identify the current primary trend structure
– Draw or mark successive highs and lows. Is the market making higher highs/higher lows (bull) or lower highs/lower lows (bear)?
4. Look for phase characteristics (optional qualitative check)
– Is activity consistent with accumulation, public participation, or distribution?
5. Seek confirmation across indices
– Wait for both chosen averages to show comparable evidence of a new high/low before committing to a call on the primary trend.
6. Check volume behavior
– Confirm the direction: rising volume on moves in the trend’s direction, lighter volume on corrections.
7. Use secondary trend rules for entries/exits
– Enter with the primary trend during pullbacks that hold key previous troughs (in a bull market) or fail to close above key previous peaks (in a bear market). Avoid acting on single-day breakouts that lack confirmation.
8. Manage risk and position size
– Set stop losses beyond structural invalidation points (e.g., below the last confirmed trough in a bull). Keep position size consistent with overall risk tolerance.
9. Reconfirm periodically
– Primary trends can take months to confirm reversals; update your analysis weekly/monthly and require index and volume confirmation before changing your market stance.
10. Combine with modern tools (optional)
– Moving averages (200-day), momentum indicators, and multiple time-frame analysis can be used to help identify and confirm trend status, but Dow Theory’s core tests—trend structure, index confirmation, and volume—remain primary.
Practical trading examples (simplified)
– Bull trend confirmation: DJIA breaks to a new primary high (daily/weekly close above prior major high). Check DJTA: if it also closes above its prior major high on rising volume, the bullish trend is corroborated and the signal is stronger.
– Bear trend warning: DJIA fails to make a new high, instead making a lower high and lower low over several weeks; DJTA also turns down on rising volume—this suggests the primary uptrend may be ending.
Important caveats and modern considerations
– The “transportation” logic: In Dow’s day railroads transported most freight; today the transport sector composition differs and supply chains are more complex. Use indices that make economic sense to pair for confirmation.
– Index composition changes and derivative markets: Modern markets have different dynamics (algorithmic trading, ETFs, global flows) that can produce faster and different kinds of moves than in Dow’s era. Dow Theory is a framework, not a precise timing system.
– Confirmation lag: Because Dow Theory emphasizes confirmed signals, it often produces late signals but tends to avoid many false breakouts. Expect trade entries/exits to lag the earliest possible pivot.
The bottom line
Dow Theory provides a disciplined framework for detecting and trading with the primary market trend. Its six tenets—market discounting, three trend types, three phases of primary trends, index confirmation, volume confirmation, and persistence of trends—offer practical rules for analysts. Modern practitioners adapt the core principles to current markets, choosing relevant index pairs and combining Dow’s ideas with contemporary tools and risk-management practices. The tradeoff is that Dow-based signals are usually conservative (they emphasize confirmation), so they may lag but tend to filter out false signals.
Sources and further reading
– Investopedia, “Dow Theory” (overview and exposition): https://www.investopedia.com/terms/d/dowtheory.asp
– Historical context: Charles H. Dow’s Wall Street Journal editorials (late 1800s–early 1900s) and classic Dow Theory expositions by early followers (for example, Robert Rhea’s writings and later summaries by William P. Hamilton).
If you’d like, I can:
– Produce a one-page Dow Theory trading checklist you can print and use.
– Walk through a recent real-market example (chart-based) applying the six tenets step-by-step.