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Dow Theory


Charles Dow and the Averages

Dow Theory - Charles Dow and the Averages; picture of a financial newspaper with the stock market page showing stock prices and a cup of coffee placed on the table for the investor to drink

The Dow Jones Industrial Average (more commonly known as the DOW) is the most famous and widely quoted market index not just in the U.S. but throughout the world. The DOW was formed in 1896 by Charles Dow and Edward Jones who also founded the Wall Street Journal. The DOW was however not the first index formed by Charles Dow, as the first Average he formed was in 1884 and consisted of 11 stocks which also included railroad stocks.

In 1896 Charles Dow split the original Average of 11 stocks into two categories, Industrials and Railroads. Charles Dow expanded the number of stocks and included 12 stocks in the Industrials Average.

In 1916 DOW Industrials was increased to include 20 stocks and in 1928 the list was again expanded to include 30 stocks which is the current number of stocks today. The Dow Jones Utility Average was not formed until 1929. The Railroad Average is now referred to as the Transportation Average and includes other transport based stocks such as airlines.

Unlike indices where the stock prices are weighted by market capitalization, the DOW Averages are simple arithmetic averages of the stock prices.

The DOW Industrials is by far the most popular average, the other two Averages constructed by Dow and Jones are the Dow Jones Transportation Average and the Dow Jones Utility Average. Both of these have nowhere near the following and are almost totally ignored by the financial press. When the financial press reports on the DOW they are specifically referring to the DOW Industrials. The DOW industrial index is closely followed by stock investors and especially stock speculators.

The Dow industrial index is the most

widely followed index in the world

Charles Dow was the editor of the Wall Street Journal and he regularly published articles which documented his observations and view of the stock markets performance (which was the New York Stock Exchange).

The Dow Jones Averages were included in The Wall Street Journal along with Charles Dow's articles describing his ideas. The Averages along with the articles provided their readers with a better understanding of the stock price movements and specifically the movements in the value of their portfolios.

Prior to Charles Dow's articles there was no real information available which rationalized the behavior of stock prices yet alone explained why stock portfolios would fluctuate the way they do. Charles Dow's articles provided the foundation for modern day technical analysis. While candlestick charting (which was an early form of market price analysis) existed prior to Charles Dow's writings, it was not known outside of Japan were it originated from.

The ideas Charles Dow's presented in his articles provided a fair amount of insight into the stock markets behavior and his most famous articles ultimately became known as the Dow Theory.

After the death of Charles Dow's in 1902, Samuel Nelson who was a friend of Charles Dow published the book The ABCs of Stock Speculation in which he named the work performed by Charles as the Dow Theory. Thus the ideas presented by Charles Dow were now known as a theory.

William Peter Hamilton who was Charles Dow's successor as editor continued to publish articles about Dow's ideas in the Wall Street Journal up until 1929. He also published a book The Stock Market Barometer in 1922 about Dow's theory.

The Dow Theory; picture of a financial newspaper with the stock prices shown for the New York stock exchange

The Dow Theory

Charles Dow viewed the stock market as an indicator of business activity. He rationalized that if the Industrial companies were prosperous then the Railroad companies which transported their manufactured goods would also be prosperous. Conversely if Industrial companies were struggling with revenue then there would be less goods to be transported and thus the Railroad companies would also be faced with a reduction in revenue.

Bull Market Reversal

Charles Dow's rationalized that if the Industrial stocks were in a bull market then the Railroad stocks would also be in a bull market. He used an average of the stock prices and noted that the Averages tended to fluctuate about somewhat in a bull market and minor corrections were common place.

The basis for Charles Dow's theory is that for a bull market to end, the Industrial Average and the Railroad Average would both end their bull market run. His theory provides a means for determining the likelihood that both Averages have ended their bull market run.

Note: The Railroad Averages is nowadays referred to as the Transport Averages.

Figure 1. below shows Charles Dow's method for determining when an Average has ended its bull market run.

Figure 1. Dow Theory Bull Market Reversal

Dow Theory Bull Market Reversal - graph showing stock price incresing and then falling with dow theory revesal

The method Charles Dow used to determine the end of an uptrend as shown in Figure 1. above is commonly used in modern technical analysis by market participants, often without even realizing that it was actually Charles Dow that first presented this method for explaining the pricing behavior of markets..

The idea behind Dow Theory is straight forward. The Average makes a Relative High and sells-off to make a Relative low and then rallies to make another Relative High and finally sells down through the Relative Low. A trend change is confirmed when the Average trades below the Relative Low.

In Dow Theory both the Industrial Average and the Railroad Average must signal a trend reversal. The signals do not need to be on the same day. The 3% minimum is set in the Dow Theory so that the rally is meaningful and not just some minor daily fluctuations.

A common variation to the chart pattern shown if Figure 1. for a bull market reversal is shown below in Figure 2.

Figure 2. Variation of Dow Theory Bull Market Reversal

variation of Dow Theory Bull Market Reversal - stock price increases higher before dow theory market reversal

From Figure 2. above, the Average made a new higher second Relative High but the reversal confirmation is still the same as the index must trade below the Relative Low to confirm the reversal.

Bear Market Reversal

In Dow Theory, for a bear market to end, both the Industrial Average and the Railroad Average must signal a trend reversal.

Figure 3. below shows Charles Dow's method for determining when an Average has ended its bear market run.

Figure 3. Dow Theory Bear Market Reversal

Dow Theory Bear Market Reversal - graph showing stock price declining and then dow theory reversal to trade back up

From Figure 3. above, the Average makes a Relative Low and rallies to make a Relative High and then sells down to make a second Relative Low. A trend change is confirmed when the Average trades above the Relative High.

A common variation to the chart pattern shown if Figure 3. for a bear market reversal is shown below in Figure 4.

Figure 4. Variation of Dow Theory Bear Market Reversal

Variation of Dow Theory Bear Market Reversal - graph shows stock trending down and then bottoms to reverse and trades back up

From Figure 4. above, the Average made a new lower second Relative Low but the reversal confirmation is still the same as the index must trade above the Relative High to confirm the reversal.

Dow Theorems

The above four charts graphically display the basis of the Dow Theory. Of course the Railroad Average is now referred to as the Transportation Average since truck transport and airline stocks are now included in the Average which were not present in the days of Charles Dow.

The Dow Theory goes further into detail regarding trends and presented some hypotheses.

The hypotheses put forward in Dow Theory are:

Dow Theory Hypotheses:

  1. Manipulation: Both Dow and Hamilton noted that the markets were frequently the subject of price manipulation in the short-term. Large account traders and Specialists (designated market makers) could move prices to their benefit. However, the long-term trend could not be manipulated as business activity would determine the direction.
  2. Averages Discount Everything: Dow Theory notes that the Market has already factored in all information, knowledge and expectations. The basis is that the market is forward looking and any new information is quickly absorbed by the market and reflected in the averages with no long-term lasting effects.
  3. The theory is not infallible: Both Dow and Hamilton noted that the work of Charles Dow was a guide to market behavior and not a means of beating the market. The primary purpose of Dow Theory is to allow the stock investor to hop on board a new bull market closer to the start and ride the bull market for as long as it lasts and exit their positions (or at least reduce their holdings) when the bear market takes hold.

The trending nature of the Averages was characterized in Dow Theory which presented the notion that prices did not move in straight lines. What is known as Relative Highs and Relative Lows were actually part of Dow Theory.

In Dow Theory, the Averages move through Peaks (Relative Highs) and Troughs (Relative Lows).

Dow Theory also characterizes trends as three types of movements, the Primary movement, the Secondary reaction and the Daily fluctuations.

Dow Theory Movements:

  1. The Primary movement is the broad general trend direction such as an up-trending bull market or a down-trending bear market. This is the trend leading up to the Relative Highs in Figures 1 & 2 and the lead up to the Relative Lows in Figures 3 & 4. In addition, Dow Theory does not forecast the extent or duration of the primary movement. The theory is only intended to identify when a primary movement has reversed.
  2. The Secondary reactions are the market corrections that go against the primary trend. For a bull market, the Secondary reaction is generally a short-term correction where the Averages are declining but may also be an intermediate-term trend. These are the short-term trends after the first Relative High in Figures 1 & 2 and after the first Relative Low in Figures 3 & 4.
  3. The Daily fluctuations in Dow Theory are basically fluctuations within the short-term swings which Dow Theory considers unimportant. Dow Theory only considers the trends important.

The Dow Theory Applied

The Dow Theory outlined above is illustrated with the actual market reversal which ended the 2002-2007 bull market and started a bear market which was labeled the 2008 financial crises.

Chart 1. Dow Theory signals for Industrial Average

Dow Theory applied to actual stock Chart showing market reversal for 2008 financial crises using dow theory today

Referring to Chart 1. the Primary movement can be determined more readily with the aid of a 12-month (260-day) simple moving average. Bull markets commonly have a 12-month moving average that slopes upwards. As can be seen on Chart 1. the 12-month moving average is sloping upwards thus confirming that the Primary movement is a bull market trend.

The Secondary reactions can be located with a 20-day simple moving average. This facilitates in locating the relative highs and lows for the short-term corrections.

As Chart 1. above shows the Dow Industrial average trades below its RL in November to signal a reversal but then trades back up again. The Dow Industrial average then trades back down below its RL again in January 2008 and this time remains below its RL.

To give a Dow Theory reversal signal the Dow Transport average must also trade below its RL. The trading action of the Dow Transport average is shown below in Chart 2.

Chart 2. Dow Theory signals for Transport Average

Dow Theory shown on  Chart for transport averages with stock price declining and then reversing with reversal signal given

Chart 2. above shows that both times when the Dow Industrial average traded below its RL the Dow Transport average also traded its RL which confirmed the Dow Theory signal.

It is quite common for the Dow Industrial average to give a signal by trading below its RL only to trade back up again and then trade back down once more.

As a general rule the Dow Theory reversal signal remains in effect as long as the Dow Industrial average remains below its RL. So in Chart 1. the signal remains in effect from January 2008.

The Dow Transport average only needs to trade below its RL to give the Dow Theory signal but after that it can trade above its RL and the Dow Theory signal still remains in effect (as is shown in Chart 2).

Summary

While Dow Theory originated over 100 years ago, the basic principles that comprise the theory are as sound today as they were back then. Granted the Railroads Average now includes other transport based stocks but they nevertheless still transport goods from the Industrial businesses. Nor has anything changed with the trending nature of stocks; they still have long-term, intermediate-term and short-term trends.

Any theory has its fair share of critics and Dow Theory is no different. Dow Theory at least points out that it is not infallible and the theory even states that it is not intended to outperform the market. Having said that, there are still some issues with the theory, in particular defining the Secondary reaction and the 3% rule can lead to extremely late signals and even missed signals. The following article on The Dow Theory for Today discusses the shortfalls of the theory and how the theory can be altered slightly so that its application is more suitable for today's markets.

The Dow Theory Today

The theory is still valid today - but it benefits from some minor alterations

The Dow Theory Today ; picture of an investor using a tablet to the check stocks trend using Dow theory for market the reversal and the new direction

In general Dow Theory has merits for speculative trading and also stock investing in general. Many market participants have totally dismissed Dow Theory as being out dated and no longer relevant to today's modern markets.

Most of the criticisms revolve around the fact that Dow Theory does not predict the tops of bull markets or the bottom of bear markets. In addition, Dow Theory provides no guidance as to the extent or duration of bull markets or bear markets.

It seems as if a lot of these critics are seeking the impossible, the crystal ball of predicting the future state of the stock market. The best that can be done is to use technical and economic information to determine the likelihood that a bull market or bear market has reversed its trend.

The basic principles of Dow Theory are sound and even the fact that it incorporates transport stocks is still valid. This is because the DOW Industrial Average essentially leads the market and their goods must be transported. The profitability of the transport companies is directly linked to the business activity of the industrial companies. Thus, if the Industrial Average declines, then the Transport Average will also decline.

The Dow Theory concept of trading below a Relative Low for the reversal of an up-trending index is firmly entrenched in technical analysis and is the bases of chart patterns such as the Double Top and the Head and Shoulders Top.

Dow Theory simply goes one step further and requires two indices consisting of different economic sectors to trigger the same signal, unlike technical analysis which only deals with one index in isolation.

Dow theory requires that both the Industrial and

Transport indices show a trend reversal

While the principles of Dow Theory are sound there are some issues with the theory which need to be considered. For those market participants who have rejected Dow Theory outright it seems as if they have not attempted to reevaluate the theory for today's markets.

At times the general rules for Secondary corrections need to be taken as a guide only and the principle of both Averages trading below their respective Relative Lows for a bull market reversal be taken as the main criteria.

Late Signals and False Signals

These are an issue with Dow Theory. Late signals are generally acceptable for bear market reversals since the preceding bull market typically run for many years and the stock investors only miss out on the bottom. However, false signals are a problem with Dow Theory.

An example of a false signal is shown below in Charts 1a.and 1b.

Chart 1a. False Signal for Industrial Average

Dow Theory today shown on stock Chart for dow industrial averages with false reversal signal given

Chart 1b. False Signal for Transport Average

Dow Theory today shown on stock Chart for transport averages - the theory gave a false reversal signal

As the above two charts show, Dow Theory gave a valid signal - The Dow Transport average confirmed the signal given by the Dow Industrial average.

Dow Theory also has a tendency to signal reversals in bull markets which actually turned out to nothing more than market corrections rather than a new bear market. In other words, Dow Theory prematurely signals an end to a bull market even though the bull market still has a long way to go.

This occurred during the 2015 market consolidation and is shown below in Charts 2a. and 2b.

Chart 2a. 2015 Consolidation - Industrial Average

Dow Theory today can produce false signals with the theory in its original state as shown for the industrial example

Chart 2b. 2015 Consolidation - Transport Average

Dow Theory today shown for dow transport average with more false signals where stock continued to trade up

As Charts 2a. and 2b. above show, Dow Theory gave a valid signal in September 2015 - The Dow Transport average confirmed the signal given by the Dow Industrial average. But the Dow Industrial then traded back up above the signal line and then traded below the once more before trading back up again and continued to trade to new highs. Thus the signal did not lead to a market reversal - it only resulted in a market consolidation before trading to new highs. The Dow Transport also gave a signal in October 2014 but the Dow Industrial did not, therefore the signal is ignored as both averages must give a signal.

Adhering strictly to Dow Theory, it cannot signal a continuation of the existing bull market since the Primary movement is an uptrend. Dow Theory can only signal a bull market when the primary movement is a downtrend. This is because Dow Theory is only intended to signal a reversal and not a continuation (if the reversal signal proved to be false). This creates a problem when the reversal signal proved to be incorrect.

A solution to this continuation problem is to alter Dow Theory's requirement of the Primary movement whenever it gives a false signal. The requirement for the Primary movement needs to be ignored when a continuation signal is required. In other words, after a false signal in a bull market, Dow Theory would ignore the fact that the Primary movement is an uptrend rather than a downtrend and the signals would be accepted.

The Dow Theory Today ; picture of an investor analyzing a stock chart on a blue glass panel with Dow theory today to provide support on the dip

Even with altering the Primary movement for a continuation, Dow Theory can take some time to signal that the bull market has resumed even though it is obvious that it has resumed. The end result is that Dow Theory falsely signaled a bear market at the bottom of the market correction and took too long to signal a continuation of the existing bull market.

One solution to the late signal issue with bull markets is to redefine the criteria for Secondary correction. Dow Theory indicates that the Secondary correction ignores the Daily fluctuations and the short-term trends. However, if the short-term trend is used for the Secondary correction together with the 3% rule, the signals become quite responsive to trend changes. Unfortunately it also increases the number of false signals but on the plus side it also provides significantly quicker confirmation of the bull market continuing.

Using the short-term trend for the Secondary correction with the 3% rule makes Dow Theory significantly more responsive and now has some practical applications for short-term investing and trading, especially with speculative strategies.

The Dow Theory Today; picture of an investor pointing at the stock chart on a curved wall panel using Dow theory today to check for stock price rally

Both Averages must confirm

This is similar to the above 3% rule where a Secondary reaction is required. One of the problems with Dow Theory is that at times only one Average displays a Secondary correction (even if it is less than 3%) and the other Average does not, even though it is holding above the Relative Low for a bull market reversal. In other words, the second Average is in a trading range rather than forming a Secondary reaction.

According to Dow Theory, a trading range is not a valid Secondary correction and thus no Dow Theory signal is given even though it penetrated its Relative Low for a bull market reversal.

The 3% rule

The 3% rule in Dow Theory is intended to filter out any minor Secondary reactions and only leave the genuine Secondary reaction. In principle this seams reasonable, however Dow Theory is based on closing prices which dictates that a line chart is appropriate.

While visually determining the trends is easier with bar charts, the problem with using a bar chart is that it becomes difficult to define the Relative Highs and Lows based on closing prices. Thus a line chart is easier to select the Relative Highs and Lows, but line charts display a lot of noise with the fluctuating daily closing prices making trends more difficult to identify.

A simple solution is to plot a 20 day Simple Moving Average (SMA) on the line chart. The 20-day SMA does a great job of highlighting the short-term trends of the DOW averages by filtering the noise which allows the Secondary corrections to be more easily determined with less ambiguity. For a Secondary correction to occur, the 20-day SMA must reverse its trend direction (a pullback in an uptrend or a sell-off in a downtrend).

The 3% rule should only be viewed as a guide and the line chart should be inspected for a Secondary correction (even if it is less than 3%) based on the 20-day SMA.

Defining the Secondary correction

Part of the criticism of Dow Theory is with identifying the Secondary correction. In the short-term there is a considerable amount of fluctuations when using the closing prices on a line chart. Plotting a 20-day SMA and tracking its trending direction along with the Relative Highs and Lows made by the Average is the simplest method of locating any reversal signals.

Charts 3a and 3b. below show the Industrial and Transport Averages with a bull market reversal signal given which turned out to be false and a continuation signal for resumption of the bull market.

Chart 3a. Dow Theory signals for Industrial Average

Dow Theory today Chart shown for dow jones average with modified theory to allow for false reversal signal

Chart 3b. Dow Theory signals for Transport Average

Dow Theory today Chart is shown again for transport averages to allow for false reversal signal when market continues to trade up

From Charts 3a and 3b. above, both Averages gave a Dow Theory bull market reversal signal. Since both Averages confirmed the signal would be taken. The problem is that this was only a market correction and not the end of the bull market. By altering Dow Theory's requirement for the Primary movement (by ignoring that requirement), both Averages signaled a continuation of the bull market.

Also the first bearish Secondary corrections on both charts (shown with red text on the charts) are obvious intermediate-term trends. However, the second bullish Secondary corrections on both charts (shown with green text on the charts) are not so obvious. This is where the 20-day SMA provides a good guide as to which Relative Highs and Lows to take.

When Dow Theory signals a genuine reversal, the Averages generally do not trade back at the signal line. If the Averages do trade back to the signal line, then in all likelihood the signal was false and the market will probably continue in its original direction and it is best to ignore the signal.

If the Averages In Charts 3a and 3b. did not trigger a continuation signal, the bull market reversal signal would likely be proved false since both Averages traded back above the red Relative Low line.

While Charts 3a and 3b. showed a continuation signal which was lower than the false signal, the continuation signal may be significantly higher than the false signal.

Conclusion

Dow Theory has its fair share of issues but for the most part it is still a useful concept, especially when applied with a few modifications. The basic idea of Dow Theory is to identify market direction which it generally does quite well. Unfortunately Dow Theory (even with the modifications) still gives some false signals.

Investing, trading and speculating all work best during bull markets. Dow Theory with some modifications allows the market participant to determine the likelihood when market conditions are not favorable (it is not a certainty). Dow Theory is a useful tool to use for market analysis but it is not something to use exclusively on its own, it is best to use Dow Theory as a supplementary tool in conjunction with other market analysis techniques.

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