Every individual who is interested and fascinated by the stock markets must know what technical analysis is. The very mention of this term springs up candlesticks, charts, patterns and calculations in all of us. But how many of us know that these concepts can be seen in theories that are more than a hundred years old, long before so many advancements that we know of. We briefly touched upon an interesting concept called ‘Dow Theory’ in one of our previous posts ‘Business cycle and how it affects the Stock Market’. In this post we will be diving much deeper into the same.
Dow Theory is one of the oldest approaches in technical analysis. The theory was initially created by Charles H. Dow (who Co-Founded Dow Jones & Company along with Edward Jones and Charles Bergstresser) in the 19th Century, which he published in the Wall Street Journal. Originally the theory focused on comparing the closing prices of 2 indices DJT and DJI, to see if they confirmed each other. Though this theory was published over 150 years ago, it surely isn’t outdated and still holds relevance in today's markets. A thorough understanding and an efficient utilisation of this theory assists investors in identifying trends in the market, and attempting to time entries and exits by analysing multiple factors like volumes, price trends and so on.
Charles H. Dow brought about and published his observations, but after his death William Hamilton continued to work on it and compiled it in the 1920’s. Later on, in the year 1932, Robert Rhea brought the work of both Charles Dow and William Hamilton together and collectively published it as Dow Theory.
Dow Theory essentially consists of 6 ideas, also called as Tenets or Principles:
1. The Market discounts all news: This Principle suggests that all the information available in a market will be accounted for and reflected in the price of a stock. This information may take any form such as earning announcements, meetings, news, investor expectations and so on. The Dow Theory thereby confirms EMH (Efficient Market Hypothesis)
2. The Market has three trends:
This theory suggests that there are 3 ways in which the market moves. The 1st trend is the Primary Trend. This is the most influential trend and it indicates the movement of the market in a long term perspective (bullish or bearish trends). It may last several months (usually 1 year) or even several years. Investors aim to analyze the Primary Trend in order to align their portfolios accordingly. The second one is the Secondary Trend which acts against the primary trend. This trend has a usual time frame of 10 days to 3 months with a movement of around 33% - 66%. The third trend is called the Short Swing Trend, in which there are minor movements that may last from a few hours to an entire month. They are thus the daily fluctuations that take place in the market. Charles Dow termed these fluctuations as noise as he felt that they were insignificant.
3. The Primary Trend has 3 phases:
The first phase in the primary trend is the Accumulation phase, in which certain investors purchase individual stocks against the general market opinion. This is the phase where investors purchase stocks they feel are undervalued. Smart Money, usually in the form of institutional investors, starts entering the market. For example, purchasing stocks that are on a downtrend, in anticipation that it is at its tail end and an uptrend will follow. The second phase is the public participation phase where investors enter the market and larger volumes of transactions take place, as they notice the acceleration of the new uptrend. It is the longest of the three phases and witnesses large movements in price. The third phase is the distribution phase or panic phase where the traders and investors sell their stocks with the assumption that the peak for a stock has been reached and a downtrend will follow.
4. Indexes must confirm with each other:
This theory suggests that for investors to reach a conclusion that a trend, be it an uptrend or a downtrend to be established, all market indexes must confirm with each other. The occurrence of a signal on one index must bring about a similarity with the signals on another index. Charles Dow used 2 indices that he brought about, one the Dow Jones Industrial Average and the Dow Jones Transportation Average to explain that to consider a growing trend in businesses based on the growth of DJIA, the DJTA must also be rising due to the increased freight requirements. Only then will it be considered as a growth trend. A similar example would be that the Nifty Large-Cap, Nifty Mid-Cap and Nifty Small-Cap must all confirm with each other to consider it as an overall trend.
5. The Volume must confirm the trend:
The volume and the level of activity in the market must correlate with the trend. For example, in a primary uptrend more investors must be entering the market. Higher volumes help in confirming the trend and proves its strength and vice versa.
6. Trends are taken to exist until there is a clear sign of reversal:
We have learnt about Newton's first law of motion which says that an object at rest, will stay at rest unless acted upon by another force. Similarly, in Dow Theory the sixth principle suggests that unless there is a clear sign that indicates that a reversal will happen such as volume shifts on an uptrend, the existing trend will continue for the foreseeable future.
Peak and Troughs are often used in the identification of trend reversals, based on the successive levels of peaks and troughs in the market. Higher highs and lows may show an uptrend and if there are successive lower highs and lows, a bearish trend may be indicated.
It is important to understand that Dow Theory is based on closing prices and is in no way connected or concerned with the movements of a stock in a particular trading day. So intraday activities have no significance in the understanding of Dow Theory. There are 4 main trading patterns concerned with Dow Theory that provide an investor a scope to identify opportunities. These are:
Double Top & Double Bottom: This is a pattern wherein a stock may reach a significant low and make a recovery for around 2 weeks before it hits its previous low level again, forming a double bottom. A Double Bottom pattern is a bullish pattern and traders can purchase these stocks. A Double Top Pattern is the bearish opposite of a double bottom, where a stock hits a significant high and dips for a period of 2 weeks or more and hits the high again.
Example of Double Top:
Similar to a Double Top & Double Bottom there also exists a Triple Top and Triple Bottom where the price hits the previous high/low as the case may be twice rather than once.
Flag Pattern: This is the case where a stock is on a tremendous uptrend and then has a correction downwards of around 10% thereby making the chart look like a flag.
Range Trading: Sideways market trends tend to create a range where the stock moves between 2 prices, making large gains difficult. But within the trading range, an investor can make profits. Example a stock that's within Rs. 75 - Rs. 120, where 75 acts as support and 120 is the resistance, then investors can make profits by trading within this range. Also, if a breakout occurs above the resistance line, then the resistance line becomes the next support line. If the stock falls below the support line, then the support line must be treated as a resistance line.
We hope that you learnt Dow Theory well and this post was insightful. Do read up on our previous post on ‘How Business Cycles Affect the Stock Market’ (https://www.earningunderway.com/post/business-cycle-and-how-it-affects-the-stock-market) for further knowledge.
- Vysravan Rajesh
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