What you need to know about the Dow Theory

Jhe Dow Theory, created by Charles H. Dow, is a collection of theories that come together to give an idea of ​​how financial markets move over time. Although it is most commonly used in technical analysis, long-term investors can use the Dow Theory to identify buying opportunities and chances to lower their cost basis for particular investments. The Dow Theory has six main parts.

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1. The market discounts all assets

One of the underlying assumptions of Dow Theory is that markets operate efficiently. In other words, all stock prices are based on all available information about the company. profits, management, competitive advantages and weakness, and everything else is factored into its price, whether or not an individual investor knows that information.

2. The market has three major trends

The Dow Theory believes that the market has three trends. The main trend lasts for more than a year and is generally classified as a bull or bear market. Bull markets are periods of rising stock prices and bear markets are periods of falling stock prices. The second type of trend occurs within the primary, often going against it and lasting up to a few months. Think about corrections or pullbacks during bull markets or rallies during bear markets. The last trend occurs during daily price movements or trends that last only a few weeks.

3. Primary trends can be broken down

The third part of the Dow Theory states that you can break down primary trends into three phases. If it’s a bull marketthe three phases are:

  • Accumulation phase
  • Public participation phase
  • Phase excess

If it’s a bear marketthe three phases are:

  • Distribution phase
  • Public participation phase
  • panic phase

4. The averages must be confirmed

Dow has created two averages — the Dow Jones Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA) — on the idea that one should reflect the state of manufacture (DIJA) and one should reflect the movement of these products in the economy (DJTA). In the Dow theory, a rise in one should also be reflected by a rise in the other. In this case, if business conditions are good (shown by an increase in the DIJA), then the transport index should also benefit from this increase. Otherwise, the trend is not sustainable.

In today’s economy, industries may vary, but the relationship between complementary industries remains the same.

5. Trends are confirmed in volume

According to the theory, the overall volume should increase if the price moves in the same direction as the main trend and vice versa. If it is low volume, it means the trend is weak. In a bull market where prices are rising, volume should rise, while falling during secondary corrections or pullbacks. If volume increases during a pullback, it could mean the trend is reversing and investors are turning more bearish.

6. Trends continue unless a definite reversal occurs

Outside of the daily swings in stock prices, Dow thought prices moved in trends. While trend changes are virtually impossible to predict, the Dow Theory assumes that a trend is currently occurring unless there is definitive evidence of a reversal.

Using Theory to Help You Achieve Your Long-Term Goals

Some traders use technical analysis like the Dow Theory exclusively to motivate their trading. At The Motley Fool, we prefer a fundamental approach that examines the underlying business behind each individual stock.

That said, even if you don’t use it for trading, the Dow Theory can be used as a resource to help you achieve your long-term goals, especially for breaking market trends like bear markets. Understanding the phases of a bear market can help prevent the panic that can accompany your portfolio’s fall, as it gives you the perspective that these trends are not only common, but almost inevitable if you invest long enough.

One of the key elements of the Dow theory is a “panic phase” during bear markets. As a long-term investor, a bear market shouldn’t cause you to panic; you should see it as a chance to prepare for the future by grabbing some of your favorite investments at a “discounted” price. Your cost base is the average price you paid per share of a company or fund. Being able to lower your cost basis during bear markets is great for investors, as it increases your profits when you possibly sell the stock in the future.

Use the Dow Theory to identify market trends, but don’t use it to try to time the market. Warren Buffett said it well: “Be fearful when others are greedy, and greedy when others are fearful.”

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Sharon D. Cole