I’ve seen a lot of blog posts about Dow Theory lately. Unfortunately, many of them have had a lot of misinformation about what Dow Theory is and how it should be applied to the markets. Like all types of technical analysis Dow Theory is simple in concept, but difficult in practice. In an effort to help you understand the basics I’ll do some posts about Dow Theory over the next several days that explain it and the basic rules of how it works. Today we’ll start with an overview.
What is Dow Theory?
In the simplest terms, Dow Theory is a study of stock market price and volume that attempts to identify the prevailing trend of the market and warn of possible changes in that trend.
William Peter Hamilton formalized the theory proposed by Charles H. Dow in a book titled “The Stock Market Barometer”. He considered the theory to be a general guide to the probable outcomes in the stock market based on the combined movements of the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA). He believed that if an investor could define the primary trend of the market and trade in that direction they would be successful. His idea was that Dow Theory could act much like a weather “forecast” that would provide broad guidance rather than specific buy and sell points.
The data of the Weather Bureau are of the highest value, but they do not pretend to predict a dry summer or a mild winter. You and I know from personal experience that the weather in New York is likely to be cold in January and hot in July.
William Peter Hamilton
He believed that when stormy conditions existed in the markets that they were likely to stall, and conversely, sunny conditions were likely to bring with them higher prices. He expected that Dow Theory be used like a barometer to warn of storms or confirm good weather. In short, the theory should help an investor identify and trade with the trend.
In our next update we’ll outline some basics of the movements in Dow Theory and how to identify them.