Understanding Dow Theory in 3 Minutes

"Dow Theory": The cornerstone of market technical analysis traces back to Dow Theory. Initially derived from the editorials of Charles Henry Dow—a journalist, the first Wall Street Journal reporter, and co-founder of Dow Jones & Company—it is often viewed as a technical analysis tool. However, Charles Dow himself considered it a barometer reflecting overall market trends. By understanding its core definitions, primary trends, and operational principles, investors can predict future price movements through price pattern analysis.

1. Basic Definition

Dow Theory is the origin of all market technical studies. Despite criticism for its lagging nature and occasional ridicule from skeptics, it remains highly respected, especially among experienced market participants. Few realize it is purely technical, based solely on market behavior rather than fundamental business statistics.

After Charles Dow's death in 1902, William Peter Hamilton and Robert Rhea refined his ideas through subsequent market commentaries, shaping the Dow Theory we know today.

As an analytical tool, Dow Theory relies on three core assumptions:

1. Market Action Discounts Everything

2. Prices Move in Trends

3. History Repeats Itself

2. Primary Trends

Dow Theory states that stock prices move with the market trend, reflecting broader conditions. Trends manifest in three forms:

1. Primary Trend (Long-Term): Lasts over a year, with most stocks rising/falling over 20%.

2. Intermediate Trend (Secondary): Counter to the primary trend, lasting over three weeks, retracing 1/3 to 2/3 of the primary move.

3. Short-Term Trend (Minor Fluctuations): Reflects transient price changes, lasting under six days.

Bull Market Traits: The primary uptrend consists of three advancing phases, interrupted by two declines (e.g., corrections). Each pullback may undercut prior lows. The cycle typically includes multiple intermediate declines and recoveries.

3. Operational Principles

Dow Theory’s principles are summarized as follows:

1. Averages Reflect Market Behavior: Market averages (calculated via closing prices) explain most market actions—Dow Theory’s greatest contribution. Modern index methodologies globally stem from this.

2. Markets Trend: Price movements fall into primary, secondary, and minor trends.

3. Primary Trends Have Three Phases: For uptrends: accumulation → public participation → excess/distribution.

4. Indexes Must Confirm Each Other: Industrial and Transportation Averages must align to validate a trend.

5. Volume Confirms Trends: Trading volume must support the trend direction.

6. Trends Persist Until Reversal: A trend remains intact until definitive reversal signals emerge.

The Essence: Dow Theory equips investors with knowledge but cannot ignore economic fundamentals or market realities. Mastering its definitions, trends, and principles enables rational investment decisions aligned with market trends.