Investors and analysts use Dow theory principles to anticipate market movements. Join us in this blog as we dissect the six tenets of Dow theory, revealing its impact on investment strategies, along with a practical example for better comprehension.
Table of Contents
Check out the following investment banking online course video to learn more about investment banking concepts:
What is Dow Theory?
The Dow theory is a foundational framework in technical analysis, founded by Charles Dow. It revolves around the idea that market trends are analyzed and confirmed through the movements of various indices, particularly the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA). The theory’s main principles highlight the importance of market movement confirmation, indicating shifts in supply and demand. Dow theory remains relevant as a guiding tool for investors.
The Dow theory originated in the late 19th century and evolved through the 20th century, refined by analysts like William Hamilton and Robert Rhea, influencing modern technical analysis. Its core principles of trend analysis and market confirmation remain relevant in the 21st century, adapting to the changing environment of financial markets and guiding investor decisions.
Take your career to the next level with an Investment Banking Certification from IIM Ranchi!
Principles of the Dow Theory
The principles of the Dow theory have a structured approach for investors to interpret market trends, enabling the identification and validation of significant market movements, ultimately leading to more strategic and informed investment decisions.
The following outlines the six tenets of the Dow theory:
Get 100% Hike!
Master Most in Demand Skills Now !
The Market Discounts Everything
The market discounts everything, which means that all sorts of information, whether we know about it or not, is already considered in stock prices. According to this theory, it’s pretty tricky to consistently beat the market using information that most people already know. It means that stock prices already reflect and consider all available information, including current economic data, company performance, and even future events like elections. This principle suggests that the market quickly adjusts stock prices to incorporate any new information. It is challenging for investors to consistently outperform the market by predicting future events.
When there’s new information, the market swiftly adjusts, and stock prices move based on what people anticipate. Investors can use this concept to find stocks that seem undervalued, hoping that the market will eventually recognize their true worth.
The Market Has Three Trends
According to the Dow theory, the market encounters three main trends: the primary trend, the secondary trend, and minor fluctuations. These principles work on stock market trends called the bull market and bear market. The bull market indicates the price of a stock or asset rising consistently, and the bear market indicates the price of a stock or asset declining consistently.
The three trends play a major role in comprehending market dynamics and offer a foundation for investors to analyze and interpret market behavior. Let us see this in detail:
- Primary Trend: The primary trend acts as the prevailing, prolonged direction of the market. It can last for extended periods of time, often ranging from several months to several years. It is the main movement that investors seek to identify when making long-term investment decisions. During a bull market, this trend is upward, reflecting general optimism and economic growth. Conversely, in a bearish market, the primary trend tends downward, indicating negativity and economic decline.
- Secondary Trend: Secondary trends are brief fluctuations that occur within the main market trend. These movements act as counter-movements, typically lasting from a few weeks to a few months. In a bull market, they appear as temporary declines within the upward trend, offering chances for investors to buy at slightly lower prices. In a bear market, they show up as temporary price increases within the overall downward trend. Although secondary reactions can cause temporary uncertainty, they do not necessarily reverse the primary trend.
- Minor Fluctuations: Minor fluctuations are the day-to-day or short-term movements in the market. They are the smallest price movements that occur regularly throughout the trading day. While they might seem erratic and unpredictable, these fluctuations do not impact the primary trend significantly. They are often a result of daily news, market noise, or short-term speculative activities.
Market Trends Have Three Phases
The Dow theory suggests that the market goes through three distinct phases, regardless of whether it’s moving up or down. This occurs in bull markets and bear markets. These unchanging stages are significant in guiding market shifts and shaping investor sentiments.
These are the three stages that the market experiences during a bullish market:
- First Phase: Accumulation Phase
The first phase is the accumulation phase, where smart investors who recognize undervalued stocks begin buying. This phase often follows a bear market or consolidation, where low prices attract investors who perceive undervaluation, signaling the start of a potential uptrend.
- Second Phase: Public Participation Phase
Here, the wider public becomes aware of a market surge (bull market) characterized by rising prices, encouraging both experienced and new investors to participate. Positive sentiment dominates, leading to increased trading activity as the market sustains its upward course.
- Third Phase: Excess Phase
In this phase, experienced investors who entered the market early and achieved substantial gains begin selling their assets to lock in profits, leading to a shift towards a downward trend, marking the end of the bull market cycle.
Below are the three phases that the market undergoes in a bearish market:
- First Phase: Distribution Phase
The distribution phase in Dow theory signifies the end of a bull market, with experienced investors selling their assets to secure profits. This phase signals a shift in the market trend as selling pressure increases, leading to a potential downturn due to decreased new investor interest.
- Second Phase: Public Participation Phase
In this phase, declining investor interest and increased public caution contribute to reduced trade volumes and prevailing negative sentiment. This phase indicates a shift characterized by declining prices and decreased investor confidence.
- Third Phase: Despair Phase
During the panic phase, there’s a rapid and sharp decline in prices, accompanied by widespread fear, high volatility, and significant selling. It’s a period when people hold negative sentiments about the market and sell due to emotions.
The Indices Must Confirm Each Other
In the Dow theory, the concept that multiple stock market indexes must move in the same direction to confirm a market trend is essential. In the Indian market, for example, the Nifty 50 and BSE Sensex are key indices. To confirm a market direction, it’s vital that both indices exhibit synchronized movements. This alignment reinforces the Dow theory’s principle that different indices within a market should support each other to validate identified trends.
The theory stresses the importance of the volume of trading activity in the indices as a confirmation of a price trend. It indicates that in a strong market trend, the volume of trading activity should either rise or maintain stability as prices progress in the expected direction. This alignment between price movements and corresponding volume is considered a sign of a healthy and sustainable market trend, reinforcing the conviction in its longevity and reliability for investors and analysts.
Trends Persist Until There is a Clear Reversal
According to Dow theory, trends keep going until there’s a big change in direction. This means that once a trend starts, it usually continues until there’s a clear change in the way the market is moving. Investors are advised to stick with ongoing trends until there’s a big change in direction that’s easy to see.
What is the Importance of Dow Theory?
The Dow theory is essential for investors, functioning as a primary instrument to understand market dynamics, enable informed investment decisions, shape long-term strategies, and reduce the risk of potential losses.
Here are several reasons that underscore the significance of the Dow theory:
- Confirmation of Trends: It helps in confirming market trends by waiting for multiple major stock market indices to move together, reducing the risk of making wrong trades. This careful approach encourages investors to validate trends by aligning movements across different indices before taking action.
- Long-Term Investment Perspective: The Dow theory is based on long-term market trends, enabling investors to sidestep impulsive responses to short-term market swings and concentrate on the long-term possibilities for growth.
- Decision-Making: It aids investors in understanding the right time for market entry or exit, guiding assessments of a trend’s potential duration, and helping to decide on maintaining investments or taking actions aligned with the confirmed trends.
- Risk Management: The Dow theory aids in risk management by enabling investors to evaluate the dependability and strength of market trends, assisting in reducing potential losses and maximizing potential gains.
- Adaptability: Its capacity to adjust to diverse market conditions and its widespread relevance in various global financial markets render it a flexible instrument for investors and analysts universally, enabling a standardized approach to analysis.
Check out the Top Investment Banking Interview Questions to crack your next interview!
Example
Rohan observes the BSE Sensex, similar to an industrial average, at 50,000 points, indicating an upward primary trend, while the NSE Nifty, representing a transportation average, stands at 15,000 points, also signaling an upward primary trend. According to the Dow theory, for bullish market confirmation, both indices should ideally move in the same direction during the primary trend.
Encouraged by the confirmation of the primary upward trend, Rohan invests ₹100,000 in selected stocks. As the market progresses, he notices a temporary secondary reaction wherein the BSE Sensex drops to 50,500 points and the NSE Nifty descends to 15,200 points. Despite this temporary setback, the overall primary trend remains intact. Rohan, following the Dow theory’s guidance, holds his investment during this phase.
Subsequently, as the market resumes its upward trajectory, the BSE Sensex climbs to 54,000 points, and the NSE Nifty reaches 16,500 points, confirming the continuation of the primary trend. Observing this upward momentum, Rohan invests an additional ₹50,000 in the same stocks, leveraging the confirmed continuation of the upward trend as guided by the Dow theory.
Rohan’s investments prove successful as the market continues its upward trend, reaching the distribution phase. During this phase, the BSE Sensex stands at 56,000 points and the NSE Nifty at 17,000 points. Rohan decided to withdraw his investments, having earned a profit of ₹40,000 based on the appreciated value of his holdings.
Having recognized the distribution phase as per the Dow theory’s principles, indicating a potential trend reversal, Rohan decides to secure his profits and withdraws his investments from the market. This adherence to the Dow theory’s principles has not only guided Rohan’s investment decisions but also assisted him in realizing profits by making informed choices aligned with market trends.
Conclusion
The Dow theory, a fundamental concept in technical analysis, offers a structured approach for investors to comprehend market behavior. Its six guiding principles aid in identifying and confirming market trends, highlighting the significance of trend confirmation, market phases, and the role of indices and trading volume. Stressing long-term perspectives and risk management, the theory assists in decision-making. Rohan’s investment experience illustrates how applying these principles leads to successful investments, profits, and informed decisions aligned with market trends.
Do you still have doubts? Contact us on our Community Page!