Dow Theory

Definition

Dow Theory is a principle of technical analysis in finance that establishes the market’s direction and trends by examining various stock market averages. It proposes that the market is in an upward trend if one of its averages (industrial or railroad) advances above a previous milestone and is accompanied by a similar advance in the other average. Conversely, if one average declines and is followed by a similar decline in the other average, the Dow theory would see this as a signal of a downward trend.

Phonetic

The phonetic pronunciation of “Dow Theory” is: “dau θɪəri”.

Key Takeaways

Sure, here’s the information in HTML format:“`html

1. The Dow Theory relies on two major concepts: The market has three movements, which include the primary trend, secondary reaction, and minor trend. The primary trend is the major market direction over a year or more. The secondary reaction is a short-term change in the primary trend, typically lasting a few weeks to months, and the minor trend is a short-term movement that lasts less than a month.
2. Dow Theory asserts that market trends are confirmed by the performance of the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA), stating that if one of these averages climbs to an intermediate high, then the other is expected to follow suit within a reasonable amount of time. The theory uses these two indices to measure the overall health of the economy.
3. Lastly, the Dow theory does not only monitor the upward and downward trends, but it also takes into account the accumulation phase and distribution phase, essential for identifying potential buy and sell signals. The accumulation phase comes before a significant market rally and is characterized by a prolonged sideways movement, while the distribution phase indicates a serious downward trend following a period of sideways market movement.

“`Please note, this HTML code will need to be added in an HTML document or editor to view the desired formatted output.

Importance

Dow Theory is incredibly significant in the field of business and finance primarily because it serves as one of the foundation stones of technical analysis. Developed by Charles Dow, co-founder of the Dow Jones Company, this theory provides a structured approach to understanding and predicting market trends, thereby aiding investors in decision-making. It emphasizes that the stock market moves in discernible trends in the short, medium, and long term, which, once identified, can forecast future price movements. Mastery of Dow Theory can therefore guide investors towards profitable investment opportunities and protect them from potential market downturns. Its principles are universal and it remains pertinent even today despite being over a century old, establishing its importance in the ever-evolving field of finance.

Explanation

Dow Theory serves a crucial purpose in financial market analysis by providing a framework to understand and predict market trends. It is used as a tool by traders, market analysts, and investors to predict and follow market trends, helping them to make informed decisions regarding their trading and investment strategies. The central principle of this theory is that market trends are reflective of all available information and factors affecting the market at any given time — including investor sentiment and expectations. Therefore, the study of these market trends can give a reliable prognosis of potential future market directions.Furthermore, Dow Theory is used to classify trends within the financial market into primary (long-term), secondary (medium-term), and minor (short-term) trends. Furthermore, it also emphasizes on the importance of volume, indicating that the volume should increase in the direction of the main trend. This adds another layer to the market analysis, expanding beyond just absolute prices. By assessing the duration and intensity of these trends and associating it with trading volume, individuals can more accurately foresee likely price movements, and therefore, deploy their financial resources more effectively.

Examples

1. Stock Market Crash in 1929: One historical example concerning Dow Theory happens to be the stock market crash in 1929 that led to the Great Depression. Prior to the crash, both Dow Jones Industrial and Rail averages hit all-time highs in the summer before trending downwards, a signal of a potential reversal in market sentiment. Despite the warning signs predicted by the Dow Theory, many investors ignored them and continued to heavily invest leading to the catastrophic crash.2. Tech Bubble in 2000: Prior to the tech bubble burst in 2000, the Dow Jones Industrial Average and the Dow Jones Transportation Average signaled a market downturn per Dow Theory, as they both didn’t make new highs together. This was an early indication of the upcoming recession where many technology-based companies saw their values plummet.3. 2007-2009 Financial Crisis: Even though the housing market was the initial trigger for the 2007-2009 financial crisis, certain stock market activities could’ve provided insight into the upcoming financial turmoil. The Dow Jones Industrial Average reached a peak in October 2007, however, the Transportation Average didn’t follow suit. According to Dow Theory, this divergence indicated an upcoming bear market which eventually led to the severe recession.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Dow Jones Industrial Average
• Technical analysis
• Market trends
• Market phases
• Stock market forecasting

Sources for More Information

• Investopedia
• The Balance
• Charles Schwab
• StockCharts