Introducing the Dow Jones Theory

6Dow4050913Charles H. Dow has been credited as the inspirational figure behind the birth of technical analysis in the form that it is known today. Dow is also famous for the development of a major US index along with Edward Jones, which is now known as the Dow Jones Industrial Average.

These two pioneers commenced their business in 1882 by delivering a handwritten newsletter, titled the ‘Customer’s Afternoon Letter’, to brokerages and banks. This document eventually evolved into the now famous Wall Street Journal and Dow remained its primary editor for many years. He was totally obsessed with the workings of the stock markets and published many revered articles on this subject.

He developed the concept of evaluating the health of the US economy by tracking the performance of an average of selected stocks in 1884. The original index comprised 11 carefully selected railway stocks but was later divided into two sections in 1986 when Dow split the industrial and transportation stocks. He demonstrated remarkable insight by identifying the significance of market sectors even in those days.

He was also quick to grasp the importance of the interaction between transportation and industrial firms. He realized that the railways would be required to transport increasing amounts of goods when industrial companies were faring well. In fact, this concept became one of the cornerstones behind his revered six basic tenets, which are now known as the Dow Theory. This theory basically identified that a relationship clearly existed between business activity and stock market trends.

 

Market Trends

Dow also postulated that the performance of the stock markets progressed in a series of trends for the majority of the time. However, he further explained that occasionally secondary trends would be created in the opposite direction to the primary ones. These secondary trends are now referred to as retracements in modern times.

He proceeded further by classifying trends into three main categories which subsequently provided the fundamental structure for technical analysis. They were:

–      Uptrends could be recognized on trading charts by identifying a sequence of higher highs and higher lows.

–      Downtrend could be recognized on trading charts by identifying a sequence of lower highs and lower lows.

–      The third trend was created when both averages traded within a restricted range by oscillating by 4% about a clearly identified mid-point. Dow referred to this pattern as trading sideways and termed it the ‘line’.

The following diagram illustrates the uptrend.

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The series of higher highs is denoted by A1, A2, A3, A4 and A5. Horizontal lines are displayed associated with these points to clearly demonstrate that each consecutive one is higher than the last. The low points of this uptrend are denoted by B1, B2, B3, B4 and B5. Again the dotted lines, identified with each one, clearly display a visibly rising pattern.

An important feature of the uptrend is that if any of the high or low points dropped beneath the value of its predecessor, then such a development was indicative that the uptrend was about to terminate. Dow advised, that under such conditions, traders should then expect that the price of the asset to begin falling imminently. He also stated that if price proceed strictly in compliance with his definition of an uptrend then it was proven and continuous.

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The above chart presents a downtrend as it definitely displays a sequence of lower highs and lower lows.

 

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The above chart illustrates the third of Dow’s trends which is termed the ‘line’. As you can confirm, price is advancing in a horizontal direction by oscillating a maximum of 4% about a mid-point. He was specifically discussing charts of averages when he defined this percentage value. As this is not the normal practice used these days, traders tend not to refer to the averages but to single stocks when discussing sideway movements. As such, oscillations exceeding well over 4% can be recorded although the asset can still be classified as moving horizontally.

Unfortunately, Dow never compiled a book containing all his incredible observations and ideas about how to analyze the financial markets because he died in 1902. However, he did produce substantial quantities of work which were published in the Wall Street Journal as editorials. All those ideas were later compiled into a book in 1903, which became famous for introducing the phrase ‘Dow Theory’. William Hamilton, who succeeded Dow as the editor of the Wall Street Journal, went on to produce another book in 1922 elaborating further on Dow’s original ideas.

Since then, many revered authors have issued many works further endorsing Dow’s concepts. Dow never considered his thoughts and concepts as a method to trade the financial markets. In contrast, he considered them as a way to assess the state and health of the nation’s economy, in general. This was because he focused on market averages as opposed to analyzing individual stocks.

 

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