What Is the Dow Theory?

1. Examining the Primary Trend of the Stock Market

In simple terms, the Dow Theory is an investment theory that studies and analyzes the primary trend of the stock market.

The stock market is like a living organism—it has vitality. Just as living beings cannot exist independently without external influences, humans rely on oxygen, sunlight, water, temperature, and food to survive. Changes in these factors affect health and vitality. Extreme heat or cold, lack of sunlight, abnormal weather, or food shortages weaken life, while moderate conditions enhance it.

The Dow Theory examines the "health" of the stock market. While the stock market resembles casino games, it differs in one key aspect: casino outcomes (e.g., dice rolls) depend purely on randomness, unaffected by external factors like the dealer’s health or room temperature. In contrast, the stock market is influenced by countless external forces.

The most direct influence on the stock market is economic fundamentals. Stocks represent ownership in companies with profit potential. Companies go public to raise capital, boosting their financial strength and profitability. The more shares an investor holds, the greater their ownership stake.

2. Studying Long-Term Market Fluctuations

A company’s stock price rises or falls based on its profitability or perceived potential. If investors believe in its potential, the stock rises; if confidence wanes, it declines.

But what affects a company’s profit potential? Beyond internal factors like management and strategy, the overarching influence is the broader economic trend. This trend can be gauged through complex economic data, including GDP, CPI, inflation/deflation, technological advancements, demographic shifts, and industrial changes. In today’s globalized economy, international conditions (e.g., financial crises) also play a role—even strong companies or economies can collapse suddenly.

These economic factors shape stock prices. Public companies are key players in the economy, both affected by and affecting these factors. Thus, the primary trend of stock prices—whether upward or downward—is dictated by economic fundamentals, including macro conditions and individual corporate health.

The Dow Theory seeks to understand how these factors impact the market. While individual stocks fluctuate based on company-specific factors, an "invisible hand" guides the overall trend, observable through market indices like the Hong Kong Hang Seng Index or the U.S. Dow Jones Industrial Average.

The Dow Theory aims to predict the market’s primary trend, which is long-term—lasting years or even decades, moving in sync with economic cycles.

3. Identifying the Market’s Rhythmic Patterns

Dow’s research revealed that stock market movements follow a rhythmic, cyclical pattern of highs and lows. The Dow Theory analyzes this cyclical nature, helping investors recognize these patterns to capitalize on market opportunities.