DOW THEORY - What is it & how can it be applied to the stock market?

Summary

The video explores the Dow Theory, developed by Charles Dow, which posits that the market is efficient and reflects all known information. It outlines six main principles, including market trends, trend phases, index confirmation, volume confirmation, and trend reversals. Despite its simplicity and usefulness for identifying trends, the theory has limitations, such as its outdated reliance on industrial indices and the efficient market hypothesis, which contradicts the possibility of beating market returns through skillful trading.

Takeaways

• 📚 The Dow Theory was developed by Charles H. Dow, co-developer of the Dow Jones Industrial Average.
• ✍️ Dow Theory was published in a series of articles in the Wall Street Journal, which Dow co-founded.
• 🔍 The theory suggests that the market is efficient and discounts all known information, making it difficult to beat market returns without higher risk.
• 📈 There are three types of market trends: primary trends lasting a year or more, secondary trends lasting three weeks to three months, and minor trends lasting less than three weeks.
• 🌊 Primary trends go through three phases: accumulation, public participation, and excess in uptrends; distribution, public participation, and despair in downtrends.
• 🔄 Dow Theory states that indices must confirm each other to establish a trend, though this aspect is considered outdated.
• 📊 Volume must confirm the trend direction; higher volume in the direction of the primary trend indicates a strong trend.
• 🔄 Trends persist until a clear reversal signal occurs, which can be identified through peak and trough analysis.
• 📉 Dow Theory can be used to analyze trends and reversals in individual securities and broader markets.
• ⏳ The Dow Theory has limitations, including its basis in early 20th-century market structures and the efficient market hypothesis, which has been challenged by active managers outperforming the market.

Q & A

Who developed the Dow Theory?

The Dow Theory was developed by Charles H. Dow, who was one of the co-developers of the Dow Jones Industrial Average in 1886.

How was the Dow Theory published?

Charles H. Dow published the theory through a series of articles in the Wall Street Journal, which he co-founded along with Edward Jones and Charles Bergstresser.

What happened to the Dow Theory after Charles H. Dow's death?

After Charles H. Dow's death in 1902, the theory was expanded and completed by his associates and followers.

How many main tenets does the Dow Theory have?

The Dow Theory has six main tenets.

What does the first tenet of the Dow Theory state?

The first tenet of the Dow Theory states that the market discounts everything, meaning that all available information is already built into stock prices.

What are the three kinds of market trends according to the Dow Theory?

According to the Dow Theory, there are primary trends, secondary trends, and minor trends. Primary trends last a year or more, secondary trends last between three weeks and three months, and minor trends last less than three weeks.

What are the three phases of primary market trends in the Dow Theory?

The three phases of primary market trends are the accumulation phase, public participation phase, and excess phase in an uptrend; and the distribution phase, public participation phase, and despair phase in a downtrend.

What does the fourth tenet of the Dow Theory state about indices?

The fourth tenet states that indices must confirm each other, meaning a trend gets established when all the major indices or market averages move in tandem.

How does the Dow Theory relate to trading volume?

The fifth tenet of the Dow Theory states that volume must confirm the trend, meaning trading volume should increase when the price is moving in the direction of the primary trend.

What does the sixth tenet of the Dow Theory say about trend persistence?

The sixth tenet states that trends persist until a clear reversal occurs, emphasizing the need for investors and traders to identify reversals and differentiate them from secondary trends.

How can the Dow Theory be used to identify trends and reversals?

The Dow Theory can be used to identify trends and reversals through peak and trough analysis, where an uptrend is indicated by higher highs and higher lows, and a downtrend is indicated by lower lows and lower highs.

What are some limitations of the Dow Theory?

Some limitations of the Dow Theory include its formulation in the 1900s using outdated economic structures and market indices, and the fact that it emphasizes the efficient market hypothesis, which has been contradicted by instances of active managers beating market returns.

How does the presenter personally apply the Dow Theory?

The presenter uses the Dow Theory loosely and prefers using moving averages to determine the trend, although they find the Dow Theory to be a potent tool for traders and investors.