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Dow Theory

Section 7, Lecture 9
Modern Technical Analysis and Dow Theory
The practice of technical analysis in some forms were present for many centuries
but Charles Dow (1851–1902) was the first to reintroduce and comment on it in
recent times.
Charles Dow developed Dow Theory while working with the Wall Street Journal back
in 1897. Robert Rhea refined by further refined the theory in 1932, and later S.A.
Nelson and William Hamilton improved the theory into what it is today. The ideas
put forward by these men have become foundation of today’s Technical
Analysis. There are six basic tenets of Dow Theory, and they are as follows –
1. The Averages Discount Everything Dow hypothesized that prices discounted
everything, including expectations, to the point that they are predictive of events.
He put forward this concept where he explained as new information arrives, market
participants quickly disseminate the information and the price adjusts accordingly,
similarly, the market averages discount and reflect everything known by all stock
market participants.
2. The Market Is Comprised of Three Movements Dow identified three types of
price change in the market. These changes are simultaneously present in the
market. These changes are known as Primary, secondary and minor movements –

Primary movements – These movements represent the broad underlying
trend. These actions are typically referred to as BULL or BEAR trends.

Secondary movements – These movements run counter to the primary trend
and is reactionary in nature. In a bull market, a secondary movement is known as a
correction and in a bear market, secondary moves are called reaction rallies or bear
market rally.

Minor movements – These are short-term movements lasting from one day to
three weeks. Secondary trends are typically comprised of some Minor trends.
3. Primary Trends Have Three Phases In this theorem, Dow postulated that
there are three Stages of Primary Bull Markets and Primary Bear Markets.
In the bull market, the first phase is made up of aggressive buying by informed
investors in anticipation of economic recovery and long-term growth. The first stage

The news from corporate are bad. The Averages Must Confirm Each Other Dow emphasized that for a primary trend or sell signal to be valid. The logic behind this hypothesis was fundamental. the first phase starts when smart money managers begin to realize that business conditions are not quite as good as once thought.” In the bear market. In order to confirm significant trend one must consider two averages or indices . This phase is characterized by a moderate decline in prices which is followed by is a reaction rally that retraces a portion of the decline. This creates a chain of demand for goods. The third and final phase of a bear market starts when all hope is lost.”The second phase of the bear market starts when the trend has been identified as down. This phase is known as “Distribution Phase. the manufacturers must transport. in this case.” The Third phase is characterized by record corporate earnings and peak economic conditions. use railways as the mode of carrying goods to consumers. and sees the largest advance in prices and most commonly known as Movement “With Strength Phase. This Phase of a primary bull market is usually the longest. The market continues to decline but at a lower pace. valuations are low. This phase is termed as “Movement With Strength Phase” and provides the largest move.of a bull market is known as “Accumulation Phase”. Dow considered a rally in the industrial average should be accompanied by a rally in the railway averages too. This phase is called “Despair phase. the economic outlook is bleak. and stocks are frowned upon. To supply the goods. 4. This period is marked by Marked by excess speculation and the appearance of inflationary pressures and termed as “Excess Phase. and thus they begin to sell the stock. so manufacturers are producing more goods to full fill the needs. thus confirming the bull market. The Second phase is characterized by increasing corporate earnings and improved economic conditions. and business conditions begin to deteriorate. both the Dow Jones Industrial and The Transport averages must confirm each other. because if the industrial rally then it suggests that manufacturing profits are up then it means consumer spending is up. but the selling continues as participants seek to sell no matter what.” In this phase. when these two indices (In case of Dow Theory these two indices were industrial .

then volume should increase during falling market. 5. The Volume Confirms the Trend The Dow Theory primarily focuses on pricing trends. If the primary trend is down. In other words. . This Theorem posited that an object in motion (in this case a trend) tends to continue in motion until some external forces cause it to change direction. 6. to confirm uncertain situations volume is only used. it is an adaptation of Newton’s First Law of motion. volume should increase during rising market. For an up-trend to reverse. an uptrend is defined by a series of higher highs and higher-lows.and the railroads index) move in tandem then only one could confirm that a major trend is in place. however. The theory states that the volume should increase along with the price in the direction of the major trend. A Trend Remains Intact Until It Gives a Definite Reversal SignalThis theorem relates a physical law to market movement. prices must have at least one lower high and one lower low then the reverse is true for a downtrend. If the primary trend is up then.