What is Dow Theory: Unveiling its Wonder or Fallacy?

Unveiling the Principles and Applications of the Dow Theory

March 16, 2024

The Dow Theory, developed by Charles Dow in the late 19th century, is a foundational framework for analyzing market trends and making informed investment decisions. At its core, the theory posits that the stock market reflects the economy’s overall health, and by studying market trends, investors can anticipate future economic conditions.

The Dow Theory provides a robust framework for analyzing market trends and making investment decisions. By incorporating the wisdom of renowned investors and philosophers, traders can develop a well-rounded approach to navigating the complexities of the stock market. Jesse Livermore once said, “There is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.” By understanding and applying the principles of the Dow Theory, investors can position themselves to capitalize on these recurring patterns and trends.

What is Dow Theory: A Timeless Framework for Market Analysis?

As the ancient Greek philosopher Plato once said, “The beginning of wisdom is the definition of terms.” The Dow Theory emphasizes the importance of patience and careful observation, echoing the principles espoused by legendary traders like Jesse Livermore. Livermore believed that no matter how much we “feel” we know, we must wait for the market to confirm our thesis before acting. He famously stated, “It never was my thinking that made the big money for me. It always was my sitting.”

Identifying and Confirming Trends

The Dow Theory identifies three types of trends: primary (long-term), secondary (intermediate), and minor (short-term). Investors look for patterns of higher highs and higher lows in the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) to confirm these trends. When both indices move in the same direction, it confirms the trend; when they diverge, it suggests a potential reversal.

Peter Lynch, the former manager of the Fidelity Magellan Fund, emphasized the importance of patience and discipline in investing. He believed that investors should focus on understanding the underlying businesses they invest in and hold their positions for the long term, aligning with the Dow Theory’s emphasis on primary trends.

The Role of Market Breadth

The Dow Theory also highlights the significance of market breadth, which refers to the number of stocks participating in a trend. A strong trend is expected to persist when many equities move in the same direction, reflecting broad market participation. Conversely, when only a few stocks drive the trend, it may be a sign of weakness and a potential reversal.

The Six Tenets of the Dow Theory

1. “The Market Discounts Everything”
Jesse Livermore, the legendary trader of the early 20th century, once said, “The market is never wrong; opinions often are.” The Dow Theory aligns with this belief, positing that the market reflects all available information, including economic, political, and social factors. As such, stock prices are believed to discount all known and knowable information.

2. “The Market Has Three Trends”
The Dow Theory recognizes three types of trends: primary (long-term), secondary (intermediate), and minor (short-term). This principle resonates with Benjamin Graham’s wisdom, who advised investors to focus on the long-term trend and ignore short-term market fluctuations. As Graham famously stated, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”

3. “Trends Have Three Phases”
According to the Dow Theory, each trend has three phases: accumulation, public participation, and distribution. This aligns with the thinking of Peter Lynch, who believed that successful investing involves buying stocks when they are out of favour (accumulation phase) and selling them when they become overvalued (distribution phase).

4. “The DJIA Confirms the Trend”
The Dow Jones Industrial Average (DJIA) confirms the prevailing trend. In an uptrend, the DJIA should make higher highs and lower lows, while in a downtrend, it should make lower and lows. This principle echoes the teachings of Warren Buffett, who emphasizes the importance of identifying and following the long-term trend.

5. “Volume Confirms the Trend”
The Dow Theory states that volume should increase toward the prevailing trend. This principle aligns with the philosophy of John Bogle, the founder of Vanguard, who believed that investors should focus on low-cost, diversified investments and avoid trying to time the market.

6. “Trends Persist Until a Reversal”
The Dow Theory holds that trends persist until there is a clear reversal, which can be signaled by a change in the DJIA or a change in volume. This principle resonates with the teachings of Charlie Munger, Buffett’s long-time business partner, who emphasizes the importance of patience and discipline in investing.

The Dow Theory in Practice: A Real-World Illustration

The Dow Theory provides a practical framework for analyzing market trends and making informed investment decisions. By studying the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA), investors can determine whether the market is in an uptrend, a downtrend, or a sideways trend and adjust their investment strategies accordingly.

Consider the market environment leading up to the global financial crisis of 2008. In the years preceding the crisis, the DJIA and DJTA were trending upwards, making higher highs and higher lows, confirming a primary uptrend according to the Dow Theory. This uptrend was accompanied by increasing trading volume, further validating the bull market’s strength.

However, by late 2007, cracks began to appear in the market’s foundation. The DJIA and DJTA started to diverge, with the DJTA failing to confirm the new highs set by the DJIA. This non-confirmation and declining trading volume signalled a potential reversal of the primary uptrend, as outlined by the Dow Theory’s principles.

Investors who heeded these warning signs and followed the Dow Theory’s guidance could have taken defensive measures, such as reducing exposure to growth stocks and shifting towards more defensive sectors like consumer staples and utilities. Those who remained patient and waited for a clear reversal signal, as advocated by the Dow Theory, would have been better positioned to navigate the following turbulent market conditions.

The global financial crisis 2008 saw the DJIA and DJTA enter a prolonged downtrend, with both indices making lower lows and lower highs, confirming a primary bearish trend. Trading volume surged, validating the strength of the sell-off. Investors who had adopted a defensive stance or exited the market entirely based on the Dow Theory’s signals would have been better positioned to weather the storm.

As this example illustrates, the Dow Theory provides a robust framework for identifying and responding to changing market conditions. By adhering to its trend identification, signal confirmation, and market breadth analysis principles, investors can make more informed decisions and better manage risk in their portfolios.

Advantages of the Dow Theory

1. “Simplicity and Clarity”
As Plato once said, “A good decision is based on knowledge, not numbers.” The Dow Theory’s simplicity is one of its greatest strengths. Its principles are easy to understand and apply, even for novice investors, providing a clear framework for analyzing market trends.

2. “Long-Term Focus”
The Dow Theory emphasizes the importance of identifying and following long-term trends, aligning with John Bogle’s philosophy of investing for the long haul. As Bogle famously stated, “Time is your friend; impulse is your enemy.” Investors can avoid being swayed by short-term market fluctuations by focusing on primary trends.

3. “Objectivity and Rationality”
In his seminal work “The Prince,” Machiavelli advocated for a pragmatic and objective approach to politics and governance. Similarly, the Dow Theory provides an objective framework for analyzing market trends, free from emotional biases and subjective interpretations.

Disadvantages of the Dow Theory

1. “Reliance on Historical Data”
While historical data can provide valuable insights, it is not always a reliable predictor of future performance. As Machiavelli cautioned, “Whoever wishes to foresee the future must consult the past; for human events ever resemble those of preceding times.”

2. “Limited Market Representation”
The Dow Theory’s reliance on the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) may not accurately represent the broader market. These indices comprise a limited number of large-cap stocks and may not capture the nuances of other market segments.

3. “Potential for Delayed Signals”
The Dow Theory’s emphasis on confirming signals through multiple indicators can sometimes lead to delayed signals, potentially causing investors to miss opportunities or react too late to changing market conditions.

What is Dow Theory? Conclusion

The Dow Theory, developed over a century ago, remains a powerful tool for investors seeking to navigate the complexities of the stock market. Its core principles, rooted in analysing market trends and the interplay between the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA), provide a time-tested framework for making informed investment decisions.

As the legendary value investor Benjamin Graham once said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” The Dow Theory aligns with this philosophy by emphasizing the importance of identifying and following long-term trends while acknowledging the existence of shorter-term fluctuations.

The theory’s emphasis on market breadth and volume as confirmatory signals resonates with the teachings of Jesse Livermore, the famous trader of the early 20th century. Livermore believed that successful trading required patience and a willingness to let the market confirm one’s thesis before acting. He famously stated, “It never was my thinking that made the big money for me. It always was my sitting.”

Moreover, the Dow Theory’s principles of objectivity and rationality echo the wisdom of Niccolò Machiavelli, who advocated for a pragmatic and dispassionate approach to governance. By providing a framework for analyzing market trends free from emotional biases and subjective interpretations, the Dow Theory enables investors to make more informed and disciplined decisions.

While the Dow Theory has limitations, its enduring relevance lies in its ability to provide a solid foundation for understanding market dynamics and identifying potential opportunities and risks. By incorporating the insights of renowned thinkers and investors, traders can develop a well-rounded approach to applying the Dow Theory in today’s ever-evolving market landscape.

Warren Buffett once said, “Successful investing takes time, discipline, and patience.” The Dow Theory embodies these principles, offering a roadmap for navigating the stock market’s inherent uncertainties while maintaining a long-term perspective. By embracing and adapting its core tenets to the modern market environment, investors can position themselves for sustained success in their investment journey.