Overview
The goal of the theory is to determine changes in the major trends or movements of the market. Markets tend to move in the direction of a trend once it becomes established, until it demonstrates a reversal. Dow theory is interested in the direction of a trend and doesn't offer any forecasting ability for determining the ultimate duration of a trend.
Much of today's technical analysis is based on Dow's original "trend following' system -
- Classification of a trend
- Principles of confirmation or divergence
- Use of volume to confirm trends
- Use of percentage retracement
- Recognition of major bull and bear markets
- Signaling the large central section of important market moves
- Dow theory has been successful in identifying 68% the major trends over the years
The three trends are:
- Uptrend: successively higher peaks (highs) and higher troughs (lows)
- Downtrend: successively lower peaks and troughs
- Sideways Channel: peaks and troughs don't successively rise or fall
Each market trend has three parts compared to tides, waves and ripples.
- The primary (major) trend or tide is a long term trend lasting from a year to several years
- The secondary trend (or mid-term trend) or wave lasts three weeks to three months and represents corrections of one third to two thirds of the previous movement - most often fifty percent of the movement.
- The minor trends (short-term trends) or insignificant ripples last less than three weeks and represent fluctuations in the secondary trend.
- Accumulation phase: knowledgeable investors buy issues with good potential
- Public Participation phase: Prices increasing rapidly and bullish markets are reported
- Distribution phase: Astute investors sell first, thereby leading the public
A Major or Long-term Stock Market Trend:
- Must be confirmed by the Dow Averages, calculated on closing prices only, not the daily high or low (this provides the overall stock market trend)
- Should have volume increase/decrease in the direction of the trend
- Stays in effect until it gives definite reversal signals
Shortcomings of the Dow Theory:
- The major criticism of the Dow Theory is its slowness: It misses about 25% of a move before giving a signal, primarily because it is a trend following system designed to identify existing trends.
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