The Dow Theory

In its basic form, the Dow theory is still the foundation of chart interpretation and applies equally to stocks, financial markets, commodities, and the wide variety of vehicles used to trade them. Its major premise is that averages remove a large amount of extraneous price motion; therefore, Dow’s original work applied exclusively to averages and not to individual stocks. In fact, Dow’s Industrial, Utility, and Transportation averages have survived the test of time. The difficulty with interpreting stock movement is in the thinness of a specific issue especially in the early part of the twentieth century; its fixed number of shares and light volume made the movement of one stock an unreliable indicator of an economic turn. Taken in total, it would be improbable to move the average by the manipulation of a single issue; hence, the averages become the subject of analysis. Commodities, especially the financial and index markets, differ from stocks in their enormous volume, as demonstrated by the Eurodollars, which can trade exceptionally high volume with only the slightest price movement. In futures, trading can be limited to one primary contract with little distortion because of constant massive arbitrage between futures and cash, and between one bank and another, especially in the interest rate and currency markets. The possibility of one trader influencing the U.S. bond market (other than the Chairman of the Federal Reserve) for more than a few seconds is remote to the point of no concern. When working in financial markets a single product is often given the same significance as a sector in the stock market when constructing a portfolio or index, yet in the footsteps of Dow, a group of international interest rates, with similar maturities, or a U.S. dollar index, can still be a valuable substitute for a single market.
The Dow theory defines price motion, as represented by the average, in three distinct primary, secondary, and minor trends. These elements have often been compared with the tide, the wave, and the ripple. The primary trend denotes the main move that exceeds 20% of the original price; the secondary trend is an adjustment or correction, and the minor movements are day-to-day fluctuations. The theory emphasizes the main move. As Angas said: “Be simple. Take the grand view.” it is easier to identify the dominant trend than to worry about every change in direction.
Accumulation and distribution are the beginning phases of a bull or bear market. Accumulation is the period in which the insiders begin to acquire a long position in anticipation of a bull move. In charting, this is traditionally seen as a wide formation at a low price with increasing open interest and erratic peaks in volume representing large purchases. The distribution phase serves the same function for anticipated bear moves.
A unique part of the original Dow theory that prevents it from being applied to commodities markets is the principle of confirmation, requiring that a signal be produced by more than one average. There has been some criticism with regard to the significance of an industrial group being confirmed by a rail, but the concept seems sound. If the purpose of the Dow theory is to identify major trends in the economy, it is unlikely that the average of one stock group would be going up and the other group moving down in a well-defined inflationary or deflationary period. In the same way, one would not expect the price of corn to increase and the price of wheat to decrease in absolute terms. A period of inflation should uniformly affect stocks and commodities; any items varying from the total pattern should be explained on an individual basis.
The relationship of the number of shares or contracts traded to the development of a price move is characterized by saying that “volume expands with the trend.” Whether a bull or bear market, activity increases as the trend becomes clear. In futures, the open interest has been treated in the same manner, with increased open interest, especially during the accumulation and distribution phases, a sign of a new move forming.
The Dow theory has other points that have been incorporated into chart interpretation. The exclusive use of closing prices is important for two reasons: (1) they are most closely followed by the typical speculator, and (2) they discount the effects of any positions taken by floor traders who are day-trading. Support and resistance lines were introduced as a substitute for the secondary move, which may have been difficult to define. Lastly, the theory expressed a trading philosophy by stating that a trend should be assumed to be intact until a reversal occurred.