Free Stock Investing Education

Dow Theory

Terminology

Dow Theory

The basic concepts behind Dow Theory were developed by Charles Dow in the late 1800s. He noted that while stock prices showed a significant amount of apparent random price movements, they did display a tendency to move in a similar fashion with each other in a broad trending like behavior. Charles Dow developed the idea of tracking the market by using an average of the largest industrial stocks and the largest railroad stocks (transport stocks nowadays). He further theorized that if the industrial stocks turned bearish then the railroad (transport) stocks that transported the goods would also turn bearish.

Line Chart

The Line Chart is a common chart style used in financial markets to study and monitor how a stocks price moves over time. The Line Chart generally shows the closing price for the day, however for very long time periods such as 10 years, it is common to only plot the closing price for the week or the month.

Moving Average

The Moving Average is an averaging calculation performed on the closing prices and is plotted as a second line on a line chart, bar chart or candlestick chart. This moving average line smoothes out the daily fluctuations in the closing price and makes trends more visually obvious.

The Dow Theory Today

The theory is still valid today - but it benefits from some minor alterations

The Dow Theory Today ; picture of an investor using a tablet to the check stocks trend using Dow theory for market the reversal and the new direction

In general Dow Theory has merits for speculative trading and also stock investing in general. Many market participants have totally dismissed Dow Theory as being out dated and no longer relevant to today's modern markets.

Most of the criticisms revolve around the fact that Dow Theory does not predict the tops of bull markets or the bottom of bear markets. In addition, Dow Theory provides no guidance as to the extent or duration of bull markets or bear markets.

It seems as if a lot of these critics are seeking the impossible, the crystal ball of predicting the future state of the stock market. The best that can be done is to use technical and economic information to determine the likelihood that a bull market or bear market has reversed its trend.

The basic principles of Dow Theory are sound and even the fact that it incorporates transport stocks is still valid. This is because the DOW Industrial Average essentially leads the market and their goods must be transported. The profitability of the transport companies is directly linked to the business activity of the industrial companies. Thus, if the Industrial Average declines, then the Transport Average will also decline.

The Dow Theory concept of trading below a Relative Low for the reversal of an up-trending index is firmly entrenched in technical analysis and is the bases of chart patterns such as the Double Top and the Head and Shoulders Top.

Dow Theory simply goes one step further and requires two indices consisting of different economic sectors to trigger the same signal, unlike technical analysis which only deals with one index in isolation.

Dow theory requires that both the Industrial and

Transport indices show a trend reversal

While the principles of Dow Theory are sound there are some issues with the theory which need to be considered. For those market participants who have rejected Dow Theory outright it seems as if they have not attempted to reevaluate the theory for today's markets.

At times the general rules for Secondary corrections need to be taken as a guide only and the principle of both Averages trading below their respective Relative Lows for a bull market reversal be taken as the main criteria.

Late Signals and False Signals

These are an issue with Dow Theory. Late signals are generally acceptable for bear market reversals since the preceding bull market typically run for many years and the stock investors only miss out on the bottom. However, false signals are a problem with Dow Theory.

An example of a false signal is shown below in Charts 1a.and 1b.

Chart 1a. False Signal for Industrial Average

Dow Theory today shown on stock Chart for dow industrial averages with false reversal signal given

Chart 1b. False Signal for Transport Average

Dow Theory today shown on stock Chart for transport averages - the theory gave a false reversal signal

As the above two charts show, Dow Theory gave a valid signal - The Dow Transport average confirmed the signal given by the Dow Industrial average.

Dow Theory also has a tendency to signal reversals in bull markets which actually turned out to nothing more than market corrections rather than a new bear market. In other words, Dow Theory prematurely signals an end to a bull market even though the bull market still has a long way to go.

This occurred during the 2015 market consolidation and is shown below in Charts 2a. and 2b.

Chart 2a. 2015 Consolidation - Industrial Average

Dow Theory today can produce false signals with the theory in its original state as shown for the industrial example

Chart 2b. 2015 Consolidation - Transport Average

Dow Theory today shown for dow transport average with more false signals where stock continued to trade up

As Charts 2a. and 2b. above show, Dow Theory gave a valid signal in September 2015 - The Dow Transport average confirmed the signal given by the Dow Industrial average. But the Dow Industrial then traded back up above the signal line and then traded below the once more before trading back up again and continued to trade to new highs. Thus the signal did not lead to a market reversal - it only resulted in a market consolidation before trading to new highs. The Dow Transport also gave a signal in October 2014 but the Dow Industrial did not, therefore the signal is ignored as both averages must give a signal.

Adhering strictly to Dow Theory, it cannot signal a continuation of the existing bull market since the Primary movement is an uptrend. Dow Theory can only signal a bull market when the primary movement is a downtrend. This is because Dow Theory is only intended to signal a reversal and not a continuation (if the reversal signal proved to be false). This creates a problem when the reversal signal proved to be incorrect.

A solution to this continuation problem is to alter Dow Theory's requirement of the Primary movement whenever it gives a false signal. The requirement for the Primary movement needs to be ignored when a continuation signal is required. In other words, after a false signal in a bull market, Dow Theory would ignore the fact that the Primary movement is an uptrend rather than a downtrend and the signals would be accepted.

The Dow Theory Today ; picture of an investor analyzing a stock chart on a blue glass panel with Dow theory today to provide support on the dip

Even with altering the Primary movement for a continuation, Dow Theory can take some time to signal that the bull market has resumed even though it is obvious that it has resumed. The end result is that Dow Theory falsely signaled a bear market at the bottom of the market correction and took too long to signal a continuation of the existing bull market.

One solution to the late signal issue with bull markets is to redefine the criteria for Secondary correction. Dow Theory indicates that the Secondary correction ignores the Daily fluctuations and the short-term trends. However, if the short-term trend is used for the Secondary correction together with the 3% rule, the signals become quite responsive to trend changes. Unfortunately it also increases the number of false signals but on the plus side it also provides significantly quicker confirmation of the bull market continuing.

Using the short-term trend for the Secondary correction with the 3% rule makes Dow Theory significantly more responsive and now has some practical applications for short-term investing and trading, especially with speculative strategies.

The Dow Theory Today; picture of an investor pointing at the stock chart on a curved wall panel using Dow theory today to check for stock price rally

Both Averages must confirm

This is similar to the above 3% rule where a Secondary reaction is required. One of the problems with Dow Theory is that at times only one Average displays a Secondary correction (even if it is less than 3%) and the other Average does not, even though it is holding above the Relative Low for a bull market reversal. In other words, the second Average is in a trading range rather than forming a Secondary reaction.

According to Dow Theory, a trading range is not a valid Secondary correction and thus no Dow Theory signal is given even though it penetrated its Relative Low for a bull market reversal.

The 3% rule

The 3% rule in Dow Theory is intended to filter out any minor Secondary reactions and only leave the genuine Secondary reaction. In principle this seams reasonable, however Dow Theory is based on closing prices which dictates that a line chart is appropriate.

While visually determining the trends is easier with bar charts, the problem with using a bar chart is that it becomes difficult to define the Relative Highs and Lows based on closing prices. Thus a line chart is easier to select the Relative Highs and Lows, but line charts display a lot of noise with the fluctuating daily closing prices making trends more difficult to identify.

A simple solution is to plot a 20 day Simple Moving Average (SMA) on the line chart. The 20-day SMA does a great job of highlighting the short-term trends of the DOW averages by filtering the noise which allows the Secondary corrections to be more easily determined with less ambiguity. For a Secondary correction to occur, the 20-day SMA must reverse its trend direction (a pullback in an uptrend or a sell-off in a downtrend).

The 3% rule should only be viewed as a guide and the line chart should be inspected for a Secondary correction (even if it is less than 3%) based on the 20-day SMA.

Defining the Secondary correction

Part of the criticism of Dow Theory is with identifying the Secondary correction. In the short-term there is a considerable amount of fluctuations when using the closing prices on a line chart. Plotting a 20-day SMA and tracking its trending direction along with the Relative Highs and Lows made by the Average is the simplest method of locating any reversal signals.

Charts 3a and 3b. below show the Industrial and Transport Averages with a bull market reversal signal given which turned out to be false and a continuation signal for resumption of the bull market.

Chart 3a. Dow Theory signals for Industrial Average

Dow Theory today Chart shown for dow jones average with modified theory to allow for false reversal signal

Chart 3b. Dow Theory signals for Transport Average

Dow Theory today Chart is shown again for transport averages to allow for false reversal signal when market continues to trade up

From Charts 3a and 3b. above, both Averages gave a Dow Theory bull market reversal signal. Since both Averages confirmed the signal would be taken. The problem is that this was only a market correction and not the end of the bull market. By altering Dow Theory's requirement for the Primary movement (by ignoring that requirement), both Averages signaled a continuation of the bull market.

Also the first bearish Secondary corrections on both charts (shown with red text on the charts) are obvious intermediate-term trends. However, the second bullish Secondary corrections on both charts (shown with green text on the charts) are not so obvious. This is where the 20-day SMA provides a good guide as to which Relative Highs and Lows to take.

When Dow Theory signals a genuine reversal, the Averages generally do not trade back at the signal line. If the Averages do trade back to the signal line, then in all likelihood the signal was false and the market will probably continue in its original direction and it is best to ignore the signal.

If the Averages In Charts 3a and 3b. did not trigger a continuation signal, the bull market reversal signal would likely be proved false since both Averages traded back above the red Relative Low line.

While Charts 3a and 3b. showed a continuation signal which was lower than the false signal, the continuation signal may be significantly higher than the false signal.

Conclusion

Dow Theory has its fair share of issues but for the most part it is still a useful concept, especially when applied with a few modifications. The basic idea of Dow Theory is to identify market direction which it generally does quite well. Unfortunately Dow Theory (even with the modifications) still gives some false signals.

Investing, trading and speculating all work best during bull markets. Dow Theory with some modifications allows the market participant to determine the likelihood when market conditions are not favorable (it is not a certainty). Dow Theory is a useful tool to use for market analysis but it is not something to use exclusively on its own, it is best to use Dow Theory as a supplementary tool in conjunction with other market analysis techniques.

StockInvesting.today

Stock Analysis for Finance Students and Investors