Dow Theory: Could this interesting theory help you beat the market?
A theory that began to take shape 150 years ago and is still partly valid today? That's exactly what the Dow Theory is. And today we're going to look at whether it can really still be applied and followed.
The Dow Theory (Sounds weird. I like the original name better) is one of the oldest and best known theories of technical market analysis. This theory was created in 1900 by American journalist Charles Dow and his colleague Edward Jones, who together founded the Wall Street Journal. Dow's theory is based on an analysis of the Dow Jones Industrial Average $^DJI+0.6%, which includes the 30 most important US stocks. This theory seeks to reveal market trends and provide useful information for investment managers and traders to make decisions about buying and selling stocks.
The Dow Theory consists of two main rules:
- The trend rule: The market is in a trend until a signal of its reversal appears. Dow distinguished three types of trends: short-term, medium-term and long-term.
- Confirmation rule: The market trend must be confirmed by another DJIA index. If the trend of a DJIA index matches the trend of another index, the trend can be considered valid. Typically, this is described on an industrial index and on a transportation index - it follows a simple logic. Factories had to transport their goods to market, usually by rail. There could not be a bull market for the industrial index unless the number and performance of railroads (and therefore their index) also increased, usually first. Both indices should therefore move in the same direction and confirm each other.
Dow's theory also focuses on other factors, such as trading volume and stock price changes, which can provide additional information about market movements.
Dow Theory is considered one of the most important approaches to technical market analysis and is still used today as an important tool for investment decision making. However, some critics argue that Dow Theory is outdated and that it does not take into account some modern factors such as high-frequency trading and global markets.
https://www.youtube.com/watch?v=ELlqEEBol6Y
These are the two main rules. But Dow Theory puts forward several other premises.
The stock market devalues all news - Stock prices quickly incorporate new information as it becomes available. As news is released, stock prices change to reflect this new information. At this point, Dow's theory agrees with one of the assumptions of the efficient market hypothesis.
Dow theorized that volume confirms price trends. When prices move on low volume, there can be many different explanations. For example, it could be an overly aggressive seller. However, when price movement is accompanied by high volume, Dow believed that this represented a "true" view of the market. To him, it was a signal that a trend was developing.
Can the Dow Theory be relied upon today?
Dow Theory is still considered one of the most important approaches to technical market analysis, and is still used as an important tool for investment decision-making by many financial market professionals today. However, since Dow Theory was created over 100 years ago, some critics claim that the theory does not take into account some modern factors.
Despite these criticisms, however, many investment managers still use Dow's theory as a basic tool for market analysis and for making decisions about buying and selling stocks. It is important to note that Dow Theory should be used in conjunction with other tools and analyses in order to gain the most comprehensive view of the market and minimize the risks involved in investing. Investors should also be cautious not to take Dow Theory as a guaranteed method for making a profit in the market, as no method of investing can be 100% reliable.
At the very least, however, I find the confirmation of indices among themselves to be a really interesting point that can suggest a lot.
What about you? Do you use Dow theory in your analyses? And did you know it at all?
Disclaimer: This is by no means an investment recommendation. It is purely my summary and analysis based on data from the internet and other sources. Investing in financial markets is risky and everyone should invest based on their own decisions. I am just an amateur sharing my opinions.
