Talking about technical analysis, the very first name that
comes to mind is Charles H. Dow—the cofounder of Dow Jones & Company and
the initial editor of The Wall Street Journal. Although Dow never published a
book formally detailing his theory, his editorials formed the basis of what we
now refer to as Dow Theory. This theory can be considered the cornerstone of
contemporary technical analysis since it established the premise that markets
trend and that those trends can be analyzed to predict future price action.
Here in this blog, let's get deep into what Dow Theory is,
its tenets, and why it is still relevant in today's algorithm driven, high speed
markets.
What is Dow Theory
Dow Theory is a theory trying to describe the way markets
function, based on price changes of stocks and indices. It implies that the
stock market contains all existing information, and based on studying trends in
price, the direction of the market can be known.
Even after over a hundred years, the fundamental concepts of
Dow Theory continue to remain the foundation for trend analysis, support resistance,
even tools such as moving averages.
The Six Tenets of Dow Theory
Dow's work was distilled into six key principles:
1. The Market
Discounts Everything
Everything available
to us today—earnings, news, economic policy, investor sentiment—is already
priced in.
This is the backbone
of technical analysis: Price is the ultimate truth.
Example: When RBI
increases interest rates, you’ll often see immediate market reactions. The
impact is already “discounted” in prices before common investors read the
headlines.
2. The Market Has
Three Trends
According to Dow, the market doesn’t move randomly. It
follows three distinct trends, similar to waves in the ocean:
1. Primary Trend (Major Wave)
Continues from 1 year
to a few years.
Involves the general direction—bullish (trend
up) or bearish (trend down).
Example: The Indian market rally postCOVID19
crash (2020–2021) was a robust primary uptrend.
2. Secondary Trend (Medium Wave)
Continues weeks to months.
Reverses the primary trend, normally by one third
to two thirds of the earlier movement.
Example: During a
prolonged bull market, an occasional 10–15% decline is merely a minor
correction.
3. Minor Trend (Small Wave)
Fluctuations of short duration covering days
to weeks.
Typically noise and hence not relied upon for
long term analysis.
3. Trends Have Three
Phases
Dow further illustrated that every primary trend goes
through three phases:
Accumulation Phase:
Institutional investors and smart money accumulate quietly when the public is
negative.
Public Participation
Phase: Trend is evident, media hype, and additional investors participate.
Distribution Phase:
Smart money sells out, prices are at the top, and late entrants purchase at the
peak.
This is highly
applicable in Indian stocks as well. Consider smallcap rallies—institutions
lead the buying initially, retail investors come in during the mania, and smart
money quietly unloads later.
4. Averages Must
Confirm Each Other
Dow employed two averages:
Dow Jones Industrial
Average (DJIA) – symbolized manufacturing firms.
Dow Jones
Transportation Average (DJTA) – symbolized railroads/shipping (the pillar of
the economy in those days).
He assumed a genuine trend exists only when both averages
are moving in the same direction.
In the current
context, we can understand it as confirmation among various indices/sectors.
For instance, if NIFTY 50 is forming new highs but BANK NIFTY is behind, the
rally will not be so strong.
5. Volume Confirms
the Trend
The price movement should be accompanied by trading volume.
When prices go up
with high volume, it supports bullish strength.
When prices go up
with low volume, the trend could be weak.
Example: When
Reliance is rising but has low traded volume, the rally could be weak. In
contrast, a breakout with huge volume is more dependable.
6. A Trend Continues
to Operate Until Definite Reversal Signals Emerge
This rule states: Don't call a trend's end until you have
convincing proof.
Marks can correct, but as long as a new high/low setup isn't
in place, the underlying trend is still in place.
Applied to practice:
Traders shouldn't freak out about mini pullbacks in an uptrend. Wait for trend
confirmation before calling a reversal.
Why Dow Theory Still Matters Today
Though it was developed in the late 1800s, Dow Theory is still
highly relevant because:
It laid the
foundation for trend following strategies like moving averages, MACD, and RSI.
Concepts like “Market
discounts everything” are the basis of efficient market hypothesis (EMH).
The psychology of
accumulation, participation, and distribution is visible in every bull and bear
market cycle.
Algorithmic traders
continue to construct strategies around price volume confirmation—a throwback
to Dow Theory.
⚖️ Drawbacks of Dow Theory
Lagging nature: As
confirmation is needed, traders can miss the early stage of the trend.
Unfit for short term
trading: Delves into long term primary trends.
No set rules: A lot
relies on interpretation, which can be different between analysts.
Conclusion
Dow Theory is not history—it's the cornerstone of technical
analysis. Sure, algorithms, AI, and world news flows may be in the driver's
seat in today's markets, but the plain fact is: markets trend, and trends are
analyzable.
If you're serious about trading or investing, learning Dow
Theory will keep you on the macro level and not mired in day to day noise.
Or as Charles Dow himself used to think: "The market is
never wrong."
