Dow theory is an interpretation of articles written by Charles Dow in Wall Street journal. In fact the term Dow theory was coined later on by people.
The basic premises of Dow theory is trend. And trend basically reflects the barometer of the trend in economic environment. The important concepts of Dow theory are:
- Price has everything: This is most popular tenets of Dow theory. It says that the price has everything known factored in it.
- The trend in a market is classified into three stages. The first phase accumulation represents the phase when the market has bottomed out and astute investors accumulate them. When the general public catches the trend, the trend moves into a public participation phase. At the peak, when markets are going to reverse, the original astute investors start selling and the phases happen the other way round.
- A trend has a long intermediate and short term trend built into it. The long term trend is more of a barometer of long term economic outlook. Intermediate and short term trend should be looked more as technical corrections in market to adjust the overbought or oversold conditions.A long term trend is basically an economic cycle.
- Dow used to track two indicators. The manufacturing and rail companies. For an economy to be in trend, both indicators should trend in the same direction. Any divergence in the indicators points to a reversal.
- Trend exists till they are reverse.
- Look for volume to validate the trend. The large volume in the direction of expected trend validates the trend. However beware at tops and bottoms.
There are again many studies which prove or disprove Dow theory and its earning potential. Mathematics and Statistics has a lot of tools to prove or disprove many things in stock market. The important take from Dow theory is about trends. The corollary is that never try to fight the trend. One will burn its finger. This has been repeated time and again by all the famous brokers and traders. Never fight the trend.
The big question still is how to find the trends. It's usually very difficult to identify medium and short term trend as they come from technical extremes, like oversold or overbought condition. However its easier to identify the long term trend. One golden rule is that when it looks that the world is going to end tomorrow and there is no solution to the problem, we have bottomed out in economy. The market may show the reaction near to it. And when it looks that we have found the never ending road to prosperity and growth the tides has turned. Also the up trend is usually slower and painful to patience. The down trend is violent and volatile. Take an analogy of climbing a hill and getting down from it.