What is the Dow Theory?

The Dow Theory is an attempt to identify trends in the movements of a stock price. It is a form of technical analysis that places emphasis on the price and volume history of a stock. The Dow Theory suggests that understanding the effect of events on the market is often more important than understanding the events themselves. It also states that trends in stock prices must be confirmed by high-volume movements in related market sectors.

The principles of the Dow Theory originated from the writings of American journalist Charles Dow, who lived from 1851 to 1902. Charles Dow founded the Wall Street Journal, a world-renowned financial publication. He also co-founded Dow Jones & Company, a firm that offers financial news and information. Dow attempted to understand and analyze market behavior by developing a set of principles. The modern understanding of the Dow Theory was formulated by scholars who scrutinized Dow’s work and writings.

One principle developed by Dow was that markets can rapidly incorporate new news. Some investors try to beat the market by using information not yet known to the general public. Markets, however, can quickly pick up on new information and reflect this information in the price of stocks. In this sense, the market “distributes” relevant news simply by altering prices. Investors don’t always need to know the original news that influences the market; rather, they need to know what effect events have on the market.

Proponents of the Dow Theory suggest that the trends in one sector of the market must be confirmed by trends in related sectors. For example, many manufacturing companies rely on transportation companies for the eventual distribution of their products. A genuine upward trend in manufacturing would be correlated with an upward trend in related transportation sectors.

In the Dow Theory, another confirmation of a developing trend is high volume in a stock. Stock volume refers to the number of transactions, buying or selling, that are taking place for a particular stock. High stock volume represents an efficient market better than low stock volume. This is analogous to the competitiveness of a general market. Price changes in a stock with low volume could be caused by a number of somewhat arbitrary factors; changes under high volume, on the other hand, tend to reflect a more general trend.

The Dow Theory also suggests that trends can exist despite significant market noise. Noise in a market refers to seemingly random movements in stock prices. According to Dow, market prices can temporarily move to follow market noise and still show a general trend in another direction.