What is a The Dow Theory The Foundation Of Technical Analysis for Cheap?

The basic premises of the Dow Theory

In 1884, Charles Dow published the first stock index. It was composed of 11 stocks. He later designed other indices and published a series of articles on the behaviour of the stock market in the Wall Street Journal, which he co-founded. He never published a book on his theory. Nevertheless, the development of chart technique and market technique, i.e. the entire technical analysis still used today, was based on his work.

Charles Dow’s theories were the subject of numerous books. As early as 1903, one year after his death, “The ABC of Stock speculation” was published by S.A. Nelson, who also introduced the term “Dow Theory”. Six core statements by Dow can be exposed.

1. The indices discount everything

The basic principle of technical analysis – it’s all in the chart! The assessments of all market participants with regard to the past, present and future, insider knowledge, etc. Unforeseeable events such as natural disasters, terrorist attacks, etc. are also quickly priced into prices.

2. There are three trends in the market

A trend in the Dow sense is a pattern of rising (or falling) relative highs and lows. The graphical connection of the respective lows or highs results in a trend line.

Dow defined three trends, which he compared to the behaviour of water in the oceans. The primary trend represents the ebb and flow of the tide, i.e. it shows the direction in which things are basically going at the moment. The secondary trend represents the waves, and the tertiary trend, which Dow called the “insignificant” trend, corresponds to the smallest changes on the waves. Dow saw the primary trends as lasting from one to several years, and the secondary as corrections of the primary trend (between 1/3 and 2/3 – correction of the previous move) usually at three weeks to three months. The subordinate (insignificant) trend, on the other hand, lasts less than three weeks and hardly played a role for Dow. He was taken with the primary trends.

3. Primary trends are three-phased

Accumulation – public participation – distribution

These are the three phases in a Dow primary bull market. In the accumulation phase, particularly informed or clever investors pick up shares cheaply. A typical case is, for example, the phase at the end of an economic downturn, when in principle all the negative factors are already known. In the phase of public participation, the news situation improves, e.g. at the beginning of an upswing. Trend followers then get on board. Distribution then begins when the mood turns to euphoria. Very high economic growth, strong profit margins, etc. indicate to the smart investors who have been collecting at the low that it is slowly time to get out, especially since the entry of the masses facilitates selling.

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4. Indices must confirm the trend

This statement refers to the industrial and railway indices. Dow believed that no general bear or bull market should be declared unless both indices give the same signal, which does not have to be simultaneous, but close in time.

5. Volume must confirm the trend

Volume must be rising in the direction of the primary trend. So if the primary trend is upward, turnover should rise as prices rise and vice versa. If it is downward, turnover should rise when prices fall and vice versa. If this is not the case, the trend must be questioned. For Dow, volume was a secondary indicator, but he paid attention to it.

6. A trend is valid until a definite reversal

Probably the most difficult element in Dow theory. Basically, one should assume that a trend continues until it turns. This corresponds to the physical principle of inertia.