The 10 building blocks of Dow Theory

February 25, 2016 09:00 AM

It is important always to keep in mind that the public views the condition of the nation’s economy as the state of the stock market. If you ask the average American what shape the country’s economy is in, that person will usually quote the Dow Jones Industrial Average. Of course that is irrational since the Dow is actually quite antiquated and only reflects 30 of the more than 10,000 publicly traded companies. Nonetheless, that is how the public views the economy. So for that reason, if for no other, the DJIA should always be kept in mind as a barometer of public sentiment.

The father of Dow Theory and the Dow Jones Index was Charles E. Dow who lived from 1851 to 1902. He was the first editor of The Wall Street Journal, where from 1900 to 1902 he authored a series of editorials setting forth his observations about the stock market. Later, Robert Rhea codified these editorials in his book “The Dow Theory” [Fraser Publishing, 1932]. It has been said that Rhea and his book, contributed more to the ‘Dow Theory’ than Charles Dow ever did.

In actuality, Dow was primarily interested in using the stock prices of, what were then, the nation’s leading companies to provide a forward-looking indicator of the national economy. Even today, the Dow Jones Industrial Average has a propensity to lead the nation’s economy from six to nine months (see “Dow indicator,” below).

Dow was not overly concerned with individual issues and applied most of his focus to his index work. Even today, the Dow purist is mostly interested in the general market. The fact is that Dow was not particularly interested in chart patterns or technical phenomena. Nevertheless, out of his efforts in developing his index, the ‘Dow Theory’ evolved. Today, Dow’s observations generally are considered to be a basic insight into market structure. And although Dow categorized intraday moves as being inconsequential, most of his observations of the larger market’s behavior have been found to be valid for smaller intraday moves as well.

A working knowledge of the ‘Dow Theory’ is a prerequisite for every trader. The following points can be said to effectively define the ‘Dow Theory: 

1: All information and emotions are defined by price.

2: In any market, three trends occur simultaneously. They are:

  • Primary trends that can persist for months or years,
  • Secondary trends that can continue for weeks or months, and
  • Minor trends that occur for days or weeks.

3: Trends usually are composed of three tests or intermediate legs.

This observation is largely what R. N. Elliott relied on to base his initial theory of Elliott Wave. These three thrusts have been widely interpreted by many technical writers to include the observation that the market moves in threes and then reverses. A fascination with the number three goes back to ancient Egypt and Pythagoras, the father of the Pythagorean theorem, and various writers have identified this scenario. For instance, Edson Gould called them, “Three steps and a stumble” and George Lindsay identified them as being, “Three peaks and a domed house.”

They are very obvious when they occur. In fact, my youngest son once observed that there was a “Rule of three… in the S&P.” 

4: Trends regularly are defined as secondary reactions.

They are an angular testing of two or more support and resistance levels  and are produced by a series of tests of higher highs with higher lows; and lower lows with lower highs. The testing of support and resistance levels is one of the most important tenets of technical analysis.

5: Any change in the trend is defined as a failure to beat the previous high or low. And failure of the larger market is defined by failure of the primary trendline.

6: Sideways price fluctuations of 5% or less usually represent either accumulation or distribution.

7: Only closing prices are used.

Even today, closing prices generally are viewed as a confirmation of market intent and are considered more important than intraday extremes. This is largely because they represent positions that people feel strongly enough about to be willing to carry overnight. Missing an intraday high or low is possible by adhering to this principle, but is considered to be inconsequential by Dow purists. The Dow Theory considers intraday highs and lows as simple aberrations.

8: The further that a trend extends, the greater the secondary reaction will be when it occurs.

9: Volume must confirm breakouts and/or exhaustion.

10: Any extreme of the Dow Industrials must be confirmed by an extreme of the Dow Transportation Index to be valid. 

In other words, both the Dow Jones Industrial Average Index and Dow Jones Transportation Index must move in the same direction and continue to print new high/lows for the dynamic trend to continue. Failure to do so is an indication of an upcoming market reversal.

The theory behind this is that if you are producing something, you must be shipping your production. And, if you are not delivering your production then you are not selling what you are making. Conversely, if you are shipping more than you are building, then the order book is weak. This actually provides a pretty broad insight into the overall economy.

Trading the Dow Theory is nothing more than applying the basic theory that a continuing series of higher highs or lower lows is indicative that a dynamic trend is established and going to continue. Conversely, if the market fails to maintain a series of higher highs or lower lows, it usually indicates a resolution of the dynamic trend. Knowledge of this can be a great hand-holder even when day trading.

One Caveat: It is worth noting that the Dow Theory of higher highs and lower lows is always late in giving signals and does not usually identify tops and bottoms until after the fact.

About the Author

Bill DeBuse has been engaged with the markets since 1959 and is presently a proprietary trader for a family foundation.