The Dow theory based on the stock price movement was introduced to the world in 1932 by William Peter Hamilton, Robert Rhea and E. George Schaefer who derived the Dow theory from 255 editorials written by Charles H Dow in the year 1900-1902 published in Wall Street journals. Dow himself never used the term Dow theory nor presented it as a trading system. Dow Theory served as an initial basis for further development of technical analysis, and nowadays it still plays an important role in the financial world.

The Dow theory is based on the 6 tenants which are as follow

1. The market has three movements

The following are the 3 movements of the market

1. The “main movement” it is considered as primary movement which can last for years. When there is a wave of rising prices, we have a rising(bull) market, when prices are declining, we have a falling (bear) market, hence the movement can be either bearish or bullish.
2. The “Medium swing” it is the secondary reaction to the primary movement which can last for 10 days to three months. This trend represents corrections in the primary trend which retracts around 33% to 66% of the previous medium swing or start of primary trend.
3. The “Short Swing” it is minor movement which last for less than a month. This trend is associated with the movements in the secondary trend. They may constitute of noise in market and may be subject to manipulation.

2. Market trends have three phases

Dow theory mentions three phase of major market trend

1. The “Accumulation Phase” in this phase the informed investors start to slowly buy/sell the stock because the realize that the change is inevitable. In this phase the stock price does not get affected much because not much part f the crowd is aware of the upcoming change.
2. The “Public Participation Phase” in this phase the stocks prices increase or decrease rapidly. It is a period marked by improving/declining business conditions and increased/decreased valuations in stocks. Earnings begin to rise/fall again and confidence starts to mend. In this stage the trend followers begin to participate.
3. The “Distribution phase” During this stage, the public is fully involved in the market, valuations are excessive and confidence is extraordinarily high and the astute investors begin to distribute their holdings to the market. Many investors become more encouraged and public participation increases, as media keeps on publishing bullish stories.

3. The stock market discounts all news

The stock prices react to the news as soon as it is public. The demand and supply of shares of the particular stocks is affected based on the nature of information. For e.g: for a company whose earnings have been affected, as soon as the news is made public there will be sell off for the particular stock.

4. Stock market averages must confirm each other

Initially, when the US was a growing industrial power, Dow had formulated the two averages. One would reflect the state of manufacturing and the other, the movement of those products in the economy. The logic was that if there is production, then those who move them about should also be benefiting, and hence new peaks in the industrial average needed to be confirmed by the peaks in the transportation average. Today, the roles have changed, but the relations remain among sectors and so does the necessity of confirmation.

5. Trends are confirmed by volume

Dow believed that volume confirmed price trends. When prices move on low volume, there could be many different explanations. An overly aggressive seller could be present for example. But when price movements are accompanied by high volume, Dow believed this represented the “true” market view. If many participants are active in a particular security, and the price moves significantly in one direction, Dow maintained that this was the direction in which the market anticipated continued movement. To him, it was a signal that a trend is developing.

6. Trends exist until definitive signals prove that they have ended

Dow believed that trends existed despite “market noise”. Markets might temporarily move in the direction opposite to the trend, but they will soon resume the prior move. The trend should be given the benefit of the doubt during these reversals. Determining whether a reversal is the start of a new trend or a temporary movement in the current trend is not easy. Dow Theorists often disagree in this determination. Technical analysis tools attempt to clarify this but they can be interpreted differently by different investors.

Dow theory helps investors to identify the facts and prevent them from making assumptions about the market which can be dangerous. Dow theory can act as fundamental base for the investors to create a guideline to carefully investigate the stocks. Dow theory helps understand the behaviour of the market and can help the investors to understand the same and make proper decisions for right stocks at right time.