In 1897 published in The Wall Street Journal, Charles Dow developed two broad market indexes which today are known as the Dow Jones Industrial Average and the Dow Jones Transportation Average. There are six assumptions under the theory which analyze general conditions in the business cycle by referring to technical points in price action. Primarily, if one of the Indexes (industrial or transportation) advances above a previous high or significant level in price – then the other is expected to follow suit. The other 6 main components of the Theory are as follows:
1. The Averages Discount Everything. This means a stock’s price is a representation of the company’s ‘fair’ value - which is assessed from all fundamental components of the stock i.e Earnings Potential, Discounted Cash-Flows, Financial Statements, Corporate Governance etc. Moreover, this principle assumes that the Theory complies with the Efficient Market Hypothesis since all market participants are assumed to have equal knowledge on all information on stocks.
2. There are three kinds of trends. A primary trend lasts for more than a year or several. A Bullish trend is when the market makes higher highs and higher lows. Conversely a Bearish trend is where the market makes lower highs and lower lows. The secondary trends can be viewed as intermediary stages during the primary, where there are corrective actions towards the primary trend typically lasting 1 to 3 months. These are believed to be one third or two-thirds of the previous movement. These correctional stages can be argued as a precursor to Elliot Wave Theory which is fractal in nature and typically has trends in waves of 3 and 5. Retracements for these waves can be measured in accordance with Fibonacci retracements where Dow Theory states corrections are most likely to retrace to 50% of the previous move.
3. Primary Trends have three phases.
a. The first phase is where the general feeling amongst most investors is very bearish where expectations about the future of prices are ‘gloom and doom’. This is also the stage where early market participants are aggressively accumulating their positions as they realize conditions are at their worst and a turnaround is inevitable.
b. The second stage is where improvement in stock fundamentals such as corporate earnings along with improved macroeconomic conditions can be seen across the market. In this early stage, debt growth is also used to finance activities that produce fast income growth and not speculation. Debt burdens are low and balance sheets are healthy.
c. The third stage (the top) is where fundamentals and price levels are at all-time highs. This is where economic conditions are at their best and investor sentiment is optimistic about the future – forward purchases of inventories occur by businesses. Crowd psychology is seen throughout this period as the general public (the heard) feels comfortable in participating in the market. Leveraged buying occurs and when the market gets ‘fully-long’, leveraged and overpriced, it becomes ripe for reversal.
4. The Averages Must Confirm Each other. For a valid change of trend to be confirmed – the Industrial and Transportations averages must both clearly show a change in a significant price level. Recently in December 2018 the Dow Jones Industrial Average fell to 21721 from its all time high of 26951. This was a drop of 19.40% which is only 0.60% off what’s considered a bear market (a 20% drop from all-time highs). During the same period the Transportations Index fell from 1162 to 864 for a loss of 23.92%. Both correctional stages would have been used to confirm a bear market had there been a continuation of trend in the Industrial Average Index.
5. Volume is used to confirm a Trend. Over the period of a trend volume should increase along with the movement. This is used to validate strength behind the prevailing trend and under the Theory, can be used to confirm the primary Trend.
6. A Trend Remains Intact Until It Gives a Definite Reversal Signal. An uptrend is defined by a series of higher highs and higher lows and vise versa for a downtrend. Dow Theory states that for a trend to reverse then at-least one lower high and one lower low must occur in price action. When a reversal in the primary trend for both Indexes occur then the probability for a continuation in the prevailing direction is at its greatest. Dow furthermore gives caution to distinguish primary from secondary trends – where often it can be difficult to assess whether an upswing is a short-term correction or a reversal pattern.