Charles Dow and His Market Theory

Charles Dow (1851–1902) wrote a series of editorials in his financial publication, The Customer's Afternoon Letter, a two-page summary of each day's financial news that in 1889 was renamed the Wall Street Journal. Dow had met his future business partner Edward Jones while the two worked together on the Providence Evening Press in Rhode Island. The two men also devised an index they called the Dow Jones Stock Average, which consisted of 11 companies (nine railroads, one steamship company, and Western Union).

In 1896, Dow created a new index of 12 stocks.

He added their prices together and divided by 12 to arrive at a simple price average. Today, index averaging is normally done in two ways. A price-weighted average like the best-known one, the Dow Jones Industrial Average (DJIA), consists of 30 industrial companies' stocks. In this kind of averaging method, higher-priced stocks have greater influence on the index than lower-priced stocks.

In the case of the DJIA, as of June 1, 2010, four companies—IBM, 3M, Chevron, and McDonalds—account for more than one-fourth of the total index value of the DJIA.

The second method of developing an index is called the capitalization-weighted average. The best-known of these are the S&P 500 and the NASDAQ Composite. Under this method, the components of the index are weighted according to the size of their total capitalization. In these averages, large price movement in higher-capitalization companies has greater influence on the index value than price movement in components with less capitalization.

Charles Dow did not develop his index theory all at once. Originally, his idea was to develop a method for tracking business trends such as earnings, as well as price trends based on price behavior among leading stocks. This concept was later given a name, the Dow Theory. Charles Dow himself never used this term, which was formalized after his death. Dow noticed that stock prices tended to move along with other, broader business trends like growth of the economy, for example. He identified business cycles as important influences on price behavior.

The first person to use the term 'Dow Theory' was S. A. Nelson in his 1903 book, The ABC of Stock Speculation.
There are six specific tenets that make up the Dow Theory as developed by William P. Hamilton, fourth editor of the Wall Street Journal, who actually developed and refined the theory:

1. Markets consist of three levels of price movement, or trends. Price behavior consists of a primary trend, a period when the direction—upward or downward—is clearly established and lasts between several months and several years. The secondary trend is a movement in the direction opposite the primary trend, in which price levels retrace the primary movement between 33 percent and 66 percent, and that lasts from a few days to a few months. The minor trend is the movement of only a few days, which may move in either direction.
2. Trends all contain three specific stages. Every trend is made up of three distinct parts. These are predictable and exact. First is the accumulation phase, a period in which contrarian and experienced investors and traders buy shares (during an uptrend) or sell shares (during a downtrend). This often occurs when overall market sentiment is to do the opposite. Second is the public participation phase, a period in which the market follows the early lead introduced during the accumulation phase, and buying or selling becomes widespread. Third is the distribution phase, the period in which those who led accumulation now sell appreciated shares or buy depressed shares, marking the last portion of the trend.
3. All news is discounted. This rule tells you that the market absorbs information, which goes into changing the price.Some price changes occur even before the news is announced, in anticipation of that news. The 'discounting' of news and information is also called 'efficiency' and this rule has been used as a rationalization of the efficient market theory.
4. Market averages have to confirm one another before a new trend can be identified. The original theory was based on the importance of the 'rails' (later changed to be called 'transportation' and to encompass trucking, shipping, and airlines). In the time of Charles Dow, the United States was expanding quickly as an industrial power, and factories needed to ship goods from widely dispersed areas into urban centers. This led to the conclusion that the strength or weakness of the transportation sector dictated the existence or change in a primary trend. Under this rule, today's Dow Theory is based on confirmation between averages. When one average begins moving, it does not represent a new trend until a second average also changes direction, confirming the new trend. For primary trends, the industrial and transportation averages are the most important indicators of trends and changes in trends. Today, the transportation sector continues to offer symptoms of economic health within the economy. The more production and selling, the more goods are moved to markets. So the transportation average is a crucial confirmation tool for industrial trends.
5. Trends in price must be confirmed further by changes in volume of trading. Dow Theory observers have noted that changes in prices and trends that occur on low volume might be false indicators, or are caused by deceptive actions such as short covering. But when price direction changes and volume are also higher than average, that is seen as additional confirmation that the trend is legitimate.
6. Trends continue in effect until signals establish a clear reversal. Trends do not simply evaporate or stop without a signal developing to show that something has taken place, often a reversal and the beginning of a new trend in the opposite direction. Short-term price movement is always chaotic, and for this reason Dow Theory observers rely on strong reversal signals, changes in volume, and other technical tools.

The Dow Theory is not perfect, but it does provide a framework for managing short-term market chaos and identifying longer-term trends. The Dow Theory employs averages, meaning everything is discounted; with this in mind, the indicators are not perfect and everything has to be confirmed.
Is the Dow Theory still valid today? With the Internet making market news and information widely and easily accessible, some critics have stated that the Dow Theory is outdated. However, especially for traders who rely on confirmation as a basic tool for timing of entry and exit, the rules governing the Dow Theory apply even in the completely automated age.

The Contrarian Approach, Mixing Speculation and Investing, Options to Leverage and Manage Your Portfolio, and A Sensible Approach to the Market present ideas that help you to combine the elements of investing and trading into a single approach to the markets. A majority of people are going to discover that their philosophy does not fit completely into either a fundamental or a technical belief system, but is more likely to rely on elements of both.