Stock Market Masters: Charles Dow Theory, Part 1

Very rarely does a person come along whose name becomes synonymous with an industry. Charles Dow, however, was such a man. When he first established the Dow Jones Industrial Average, I dare say this quiet man from Connecticut had no aspirations for his index to be referenced as “the stock market” 100 years later on the nightly news. But that is exactly what happened. First published in 1896, the Dow Jones Industrial average is so closely aligned with the stock market and overall economic health that one may mistakenly assume Dow invented the market itself! Often news announcers and columnists alike will say, “The stock market moved 86 points today,” when in reality they are saying, “The Dow Jones Industrial Average moved 86 points today.”

It is more interesting still that relatively few people have a clue of Dow’s genuine contribution to the world of finance and specifically stock market analysis. So to honor Dow, I have written a series of 7 articles explaining what has become known as “Dow Theory” in this section of Stock Market Masters. These articles have now been compiled as individual sections in this single featured article.

Section Index:

Introduction to Charles Dow

Charles Dow was the son of a farmer, born on November 5th, 1851, in Sterling, Connecticut. Regarded by many as a quiet, honest man, what Dow lacked in formal education he made up for in pure tenacity and determination to discover the truth. His strong will and knack for investigation led him to become a journalist at the age of 21 and eventually led him into the field of financial journalism. By the age of 29, Charles Dow found himself in the big city of New York writing daily financial columns.

In 1889 Dow and his buddy Edward Jones started and published the first edition of the Wall Street Journal. By 1896 Dow had researched the most influential movers of the economy and devised an index to track the overall market. The first issue of the index was comprised of only 12 stocks, all stocks which were said to represent the industrial side of the country’s economic well being. Just a few short months later, Dow began to also publish a transportation index that initially consisted of 11 companies, 9 railroad and 2 non-railroad stocks. Even though these two indexes have grown to represent 50 companies (30 in the industrial average and 20 in the transportation average) and several companies have come and gone from the indexes, they are still in common use today and are considered by many to be extremely accurate gauges of the overall health of the economy.

While these two indexes bearing the name “Dow Jones” are certainly the most widely recognized claim to fame for Charles Dow, some would argue they are not his greatest achievement. It is fair to say Dow actually created one of the first technical indicators through the use of his index, a monumental contribution to the world of financial analysis in and of itself. But at the same time, Dow published in the Wall Street Journal a series of articles that outlined and documented his observations on the market, particularly as it related to the indexes. These writings would later become known as “Dow Theory” and would earn him the title as “The Father of Technical Analysis” in most circles.

The Establishment of a Theory

Charles Dow himself never referred to his writings as “Dow Theory.” That title was attributed to his work by William Peter Hamilton (Dow’s successor at the Journal). Through continued research and compilation, Hamilton codified Dow’s work and rightly credited it as “Dow Theory” in his book The Stock Market Barometer in 1922.

Throughout most of the 20th century, Dow Theory was dismissed by many as irrelevant, mostly because of some incomplete studies performed by Alfred Cowles in 1937. However, in more recent years Dow’s principles surrounding how the market moves have been resurrected. With the advent of modern tools, traders have begun turning to technical analysis as a preferred method of analyzing stocks to the more traditional methods of fundamental analysis. In the process, the theories of Charles Dow have been brought to new light and newer studies have proven them to be incredibly accurate and a great insight into market behavior (Kirkpatrick 74).

On the most basic level, Dow’s principles of market behavior can be summarized into six basic tenets. They are:

  • The price discounts everything.
  • The market has 3 trends.
  • Major trends have 3 phases.
  • The averages must confirm each other.
  • Volume must confirm the trend.
  • A trend is assumed to be in effect until it gives definite signals that it has reversed.

These tenets form the basis for Dow Theory and can give both the trader and the investor great insight into likely future moves of a stock.

Stock Market Masters: Charles Dow Theory, Part 2

This first tenet of Dow Theory is in many ways the most difficult to accept for many investors. This is because most beginning investors/traders have learned at least some basic concepts of investing by following fundamental analysis. In the world of fundamental analysis an investor studies all the different fundamental factors of a company to determine if it is trading at a fair market value. These factors include such things as price/earnings ratios, company cash flow, dividend payments, etc. Most fundamental analysts also look at future projected growth through new product offerings, potential acquisitions, new competition, and other similar factors. For the fundamental analyst these factors form the basis of their investing decisions.

The goal of the fundamental analyst is to observe all of these various factors and determine what he/she believes the future value of the company will be worth. If the company’s current stock price is substantially below the projected value, then the company is worth investing in. The strategy of a fundamental investor is to buy a stock when it is trading at a good value and hold it while the stock rises with the company’s future performance.

In and of itself there is nothing wrong with the theory of fundamental investing. But Charles Dow discovered many years ago (over 100!) that it does not take long for the fundamentals of a company to be observed by the majority of the people buying that company’s stock. This observation is the basis for the tenet that the price discounts everything.

What Dow meant is simply this: All the fundamental data has already been factored into the purchase of a stock. Consequently the current price at which a stock is trading is not as much directly related to the fundamental value of the stock as much as it is related to the speculation of the traders as to the future value of the stock.

When I teach this principle to my students, I often say the observation this way: There are only four days a year when the core fundamental data changes for a company (as far as the public is concerned)—the four earnings days. Earnings are announced once a quarter, and on that day companies come out and make statements concerning overall company health and also give projections for the future earnings. But the price of a stock changes on a daily basis. If the fundamental data alone were to determine the price of the stock, then after the initial release of data investors would rush to re-price the stock at a fair market price in line with the company’s newly released fundamental data. Then the price of that stock would stay the same until the next earnings announcement, at which point the investors would again re-price the stock to the current fair market price.

However, this is not what we see. What we see in the price of a stock is a very quick adjustment in price after earnings are released. Then every day between this adjustment and the next earnings release the price of the stock moves. For many stocks that move may be 40-60% or more of the value of the stock! So my question is this: If the core fundamental data only changes four times a year (on earnings day), what causes the price to move the other 361 days a year (holidays and weekends not included)?

The answer is investor anticipation, generally through assumed (or speculative) circumstance. This is exactly what Charles Dow mean when he said the price discounts everything. The price, as it is reflected today, has already factored in to it the most recent changes in fundamental data. Thus, all price moves from here forward until the next release of fundamental data is not a reflection of core company value but of the speculation of the traders and investors who are expecting the price to be worth more (or less) in the future.

As an investor this is solid information to know and understand. What it means to you is it may be useless to spend hours pouring over hard fundamental data. After all, there are high-paid analysts who do nothing but pour over that very data. In the words of one of my mentors, “What makes you so special that you are the first to see the opportunity?” (Hint: You’re not!) That’s why it is beneficial to move beyond fundamental analysis and analyze a stock’s price behavior apart from the fundamentals alone.

Back to index

The Market Has 3 Trends

While observing the markets, Charles Dow observed that the market tends to move in predictable trends. Not only that, but these trends also seem to move in sub-trends. This observation led to the idea that the market (or an individual stock) always has 3 trends at work. The 3 trends are:

1. Primary (Long-term Trend)

The primary trend is the large, big picture move that a stock is in. This trend can be anywhere from 2-5 years in length and is the main movement of the stock over time.

2. Intermediate (Mid-term Counter Trend)

The intermediate trend is one that usually moves counter to the large trend. (Truth be told, it can move with the primary trend as well, but when it’s moving with the primary trend it seems to blend in and is considered part of the primary move.) Dow said this mid-term trend usually lasts 6-9 months. However, I have certainly observed my share of shorter intermediate trends, and I adjust that timeframe down to 3-9 months. Either way you look at the timeframe, the effect is still the same. The intermediate trend moves on top of the larger primary trend.

3. Minor (Short-term Trend)

The minor short-term trend is just that. It moves on top of the intermediate trend as part of the overall primary move. Minor trends can be anywhere from a few days up to 3-4 weeks. While they can be a chance for a decent profit, sometimes the moves occur so fast it is very difficult to enter the trade. Often times by the time a minor trend is established, the trade is over. Still, it is good to understand how the minor trend works, and we can use it to time better entries into a trade within the more manageable intermediate trend.

Like Waves on the Ocean

To help draw a visual, Dow likened the three trends to the waves of the ocean. He said the primary trend is like the tide of the ocean. It moves in and out in a large cycle. The intermediate trend is like the waves of the ocean. They sometimes move with the tide and sometimes against it, but they form part of the motion of the ocean’s water movements. And finally, he likened the ripples on the waves to the minor or short-term trends.

Understanding these trends and the likely natural cycles of the market can give you a distinct advantage when placing your trades. When you understand how a market’s trends move, you will have a better likelihood of being on the right side of that trend, and that will lead you to greater profitability!

Back to index

Major Trends Have 3 Phases

Way back in the late 1800s when Charles Dow first wrote his observations in the Wall Street Journal very few people had taken the time to actually analyze the moves of a stock, much less the whole market. The tools of technical analysis were years from being developed, and in many ways people considered the speculation of trading/investing in the stock market nothing short of gambling. But in his study of market behavior, Charles Dow made some interesting discoveries. One of those discoveries is the order in which people enter the market. And this order is summed up in the third tenet of Dow Theory: major trends have 3 phases.

Accumulation - The first phase of a trend is what Dow termed the Accumulation Phase. During the accumulation phase Dow theorized that some investors, for whatever reason, were able to foresee the future price of a security and managed to buy at, or near, the low of the stock’s price swing. Dow said these individuals do not in and of themselves hold enough buying power to move the market, but they begin to buy up stock and “accumulate” their positions in anticipation of the next big move. As prices stabilize during the accumulation phase, the public begins to trust the market a little more. Eventually the public begins to put their money into the market, and the accumulation phase completes as we move into the second phase.

Public Participation - The Public Participation Phase is where the bulk of the price movement occurs. During this time the public’s confidence in the stock begins to rise, and more and more people begin to place their money in the trade. As the buying pressure grows, so does the price of the stock, thus driving the price even higher. As the price continues to rise, public confidence rises even more, attracting more money and driving the price even higher. Eventually the optimism that drove the stock to its new highs spreads like a virus and most of the available money of the general investor is placed in the trade. This overexposure leads to a lack of buyers and consequently leads us to the third phase of the trend.

Distribution - In the Distribution Phase the very investors who began the move by accumulating their positions are the first to exit the move and “distribute” their positions. These more insightful investors, who in Dow’s mind somehow foresaw the upcoming move, are also insightful enough to realize the market has moved as far as it will move and the time has come to exit their position. Dow also points out that while these insightful investors seem to have an inherent understanding of the price move of the stock and close their positions, the public’s optimism is at its highest and begins to attract the latecomers who begin to believe this stock must surely continue higher. It is during this time that the major news outlets also begin to print the most optimistic news stories, which bolsters the public’s sentiment that things must continue higher. This good press builds the optimism and sets the public at ease.

As the distribution phase gets under way and the original money that started the move in the accumulation phase is removed from the market, the public has fully vested their positions and sits anxiously in anticipation of a continuing higher move. However, since the availability of fresh funds has dried up and ceased, the continuing rise in price has also ceased. With the original money now gone from the market, prices begin to fall, and the public—who so eagerly helped to drive the market up in a frenzy with the help of the optimistic news media—now begins to doubt their positions. This doubt leads to an equal and opposite selling frenzy, which drives the market back down—often to the same place it began the move. Once the stock has been driven back to the lows, the very people who began the accumulation phase and participated in the distribution phase once again enter the market, accumulating new positions in anticipation of the next cycle of rising prices.

For the uneducated investor, this scenario seems like market manipulation. However, manipulation is not what is occurring—it is insightful market observation. This tenet is one of Charles Dow’s greatest contributions to the world of market analysis as it gives insight into the cycles of market behavior. When you understand how market cycles tend to behave, you can learn to enter the markets during the accumulation phase, when most people believe the stock is doomed forever. And when most consider the stock to be rising to the heavens with no end in sight, you can be insightful enough to know when to close and distribute your positions. This will make you an exponentially more profitable trader.

It is worth noting that this particular tenet of Dow Theory eventually led to a further study of market behavior, one that focuses entirely on the position of contrary opinion. Investing as a contrarian can be a very profitable position if and when you understand how to use it. This subject will be covered in more detail in an upcoming article series.

Back to index

The Averages Must Confirm Each Other

As I mentioned in Part 1 of this series, one of Dow’s best-known contributions to the world of stock market analysis is the stock indexes that bear his name. So popular and well known is the Dow Jones Industrial Average that many mistakenly refer to it as “the market”! In fact the industrial index is really nothing more than an index of 30 stocks that track major industry in America.

Back in 1896 when Charles Dow and Edward Jones first created the index, they started with 12 companies. Just a few short months later they created another index known as the Dow Jones Transportation Index. The Dow Transports, as it is often called, was created to track the transportation sector of the market. The original index included the stocks of 9 railroads and 2 non-railroad companies.

The reasoning behind the fourth tenet of Dow Theory goes like this: If the industries in America are doing well and creating goods, the industrial index will move higher. If the goods being created are being shipped to customers, then the transportation index will go higher as well. If, however, the goods are being created but not being shipped, then the industrial index will ultimately fall because of a lack of demand for goods.

This idea leads to the concept of Index Divergence, which says that when the indexes are moving in the same direction, they confirm each other and thus confirm the state of the economy. If, however, the indexes begin to move in different directions (diverge), then the indexes are alerting us to a larger fundamental problem.

Let’s try to put some hard numbers with this and drive the point home a little more. Let’s say the industrial index has moved from 350 up to 400, but the transportation index has moved from 225 down to 200—the two indexes are moving in opposite directions. This is called divergence. What it means (in theory) is that while a greater number of goods are being produced, those goods are not actually shipping. The lower transport levels show a slow down in shipments, which inevitably will lead to a slow down in production and consequently a lower tracking in the index.

This concept of following the indexes and making sure the indexes confirm each other was a very early form of a technical indicator. Today this particular tenant of Dow Theory is less applicable than some of the other tenets, as we have several other indicators that may help us better understand what the market is doing. But at the time of Dow’s writings, this was revolutionary. It’s one of the many things Dow did to earn himself the title “The Father of Technical Analysis.”

Back to index

Volume Must Confirm the Trend

The fifth tenet of Dow Theory is strongly linked with the third tenet. If you remember, the third tenet states that a trend has 3 phases, Accumulation, Public Participation, and Distribution. The middle phase, public participation, is tightly connected with the fifth tenet concerning volume.

When a group of investors begin to accumulate a new position, they are generally working on contrary opinion. Consequently they are all alone. This is the time when most of the money has been pulled out of a stock and there are few people left to trade it. But as the accumulators begin to take their position and the price of the stock rises, it grabs the attention of the public. As the public takes note of the rising prices and begins to enter their own positions, the volume of shares traded begins to rise.

Dow theorized that a rising price without rising volume was not a confirmation of public participation. Since the public participation phase is when the largest moves are garnered, the ideal scenario is to get in at the beginning of the public’s participation and get out at or near the end. But if volume does not rise as well, then the rising price may not be sustainable, and it is a sign of a weak trend.

Volume is one of the easiest indicators to work with. It’s quite simple in that it merely reflects how many shares trade hands on that particular day. Whether the trend is rising or falling, volume should be rising to confirm the general public has jumped into the trade and is helping to perpetuate the move. If volume does not support the trend, it does not mean the price will not move. It simply reflects that the number of people trading is low and the trend may be a weak trend.

If you would like to learn how to apply Dow Theory and the importance of volume to your own trading, please visit our website and sign up for a free class. In Part 7 we will look at the sixth and final tenet of Dow Theory and explain how you can use it to better time your trades and understand the next move of a stock.

Back to index

A Trend Is Assumed to Be in Effect Until It Gives Definite Signals That It Has Reversed

This sixth and final tenet of Dow Theory is technically one of the simplest points. It speaks to an underlying emotion that has cost many a trader quite a pretty penny. When a person analyzes a trade, the real goal is to answer three small but essential questions:

  • At what price do I enter the trade?
  • At what price do I exit to take a profit?
  • At what price do I exit because the trade has gone against me?

These three questions are quite simple, yet few traders actually take the time to answer them before entering a trade. Of these questions, it is the last one that is really tough to handle. After all, no one ever wants to close a trade for a loss, much less plan before entering the trade what would be an acceptable level of loss. In fact it’s such a tough subject that most people choose to ignore it and focus instead on all the money they are going to make with the trade.

This is why Dow’s point about a trend still being in effect is so important. Understanding where the trends are and where a stock is trading in that trend is critical to being able to answer the three questions outlined above. Dow’s theories on market behavior make our job a lot easier. If we know before we enter a trade where the trend is, which part of the trend we are in, and where the trend is likely going, then we can enter and exit the trade with more confidence. Making educated decisions about entries and exits (as opposed to wild guesses) means we can more effectively plan our trades.

Applying the First Five Tenets of Dow Theory

By taking into account the first five tenets of Dow Theory (specifically as it relates to trends), a smart trader can account for the next likely move. If we know that the fundamental data is factored into the price already, we will not be swayed by the emotion of speculation as much (Tenet 1). If we understand that the market (as well as an individual stock) moves in simultaneous trends (Primary, Intermediate, Minor), we can better lay out and organize those trends and then trade off of that knowledge (Tenet 2). If we understand the development of a trend (Accumulation, Public Participation, Distribution), we can better understand the life cycle of that trend and where the stock is currently trading in that cycle (Tenet 3).

By confirming our analysis through indexes and indicators, we can feel more confident about our analysis and confirm our thoughts (Tenet 4). And by understanding how the public feels about a trend through their participation (as measured by volume), we can measure the strength of a trend and the likelihood of it following through (Tenet 5). With all of this information now before us, we are better prepared to answer the three key questions before we enter the trade.

Knowing When to Get Out

The first five tenets help us understand the direction of the trend and how to get into the trade. The sixth one tells us where to get out. Generally speaking, it is okay to stay in a trade as long as the trend is continuing. However, once the trend breaks its pattern, it is confirming that the trade is no longer valid. And this is when you must close your trade. If a stock’s trend cannot be patterned, then it cannot be predictable, and you cannot trade it for profit. You must step back, reanalyze, and find a better strategy to trade that stock or else move on to a less complicated trade.


So how do you use this tenet to know where to exit your trade? Technically you can’t. The theory in and of itself doesn’t give you the specifics. It just gives you a conceptual look at timing and when you should stop trading that move. In order to time your trends and know when you should close the trade, you need to implement other levels of analysis. Different traders may choose to follow different systems for that analysis. As for me, I teach my students to follow multiple steps to confirm their moves. They include:

  • Support and Resistance Analysis
  • Price Target Analysis
  • Chart Pattern Analysis
  • Candlestick Pattern Analysis
  • Indicator Analysis (for final confirmation)

As a trader you can work with your own systems to determine what your personal triggers will be for confirmation that the trend has been broken. The five-step system above works for me every time. But no matter which way you choose to do your more detailed analysis, Dow’s theory that we should close the trade once the trend has confirmed it is no longer in effect is certainly a lesson all traders can learn from. After all, you can’t logically buy and hold forever (despite what some financial planners would tell you).

Charles Dow’s contributions to technical analysis have certainly changed the way equities are analyzed for trading. Even though his theories are over one hundred years old, they are just as relevant today as they were when he first wrote them in the late 1800s.

Bibliography:

Kirkpatrick, Charles D. and Julie R. Dahlquist. Technical Analysis: The Complete Resource for Financial Market Technicians. Upper Saddle River, New Jersey: FT Press, 2007.

Murphy, John J. Technical Analysis of the Financial Markets. Paramus, New Jersey: New York Institute of Finance, 1999.

“Charles Dow.” http://en.wikipedia.org/wiki/Charles_Dow, accessed 8/4/09.