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Dow Theory: Curbing Emotional Investing

January 13, 2021
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In addition to starting the company that publishes The Wall Street Journal, Charles Dow (1851–1902) also lent his name to one of the most popular U.S. stock market indexes (the Dow Jones Industrial Average) and created a theory regarding major shifts in stock market trends. While neither Dow nor those who refined the Dow theory after him believed they were creating a sure-fire way to beat the market, they did believe that following its principles could at least avoid the mistakes associated with greed and fear.


Three Assumptions

Behind the Dow theory is a set of assumptions about how the stock market works:

  • The stock market moves in broad cyclical trends. According to Dow, there are primary trends, which are long lasting (from months to years), and minor trends, which don’t last long and run in the opposite direction of the primary trend. Primary up trends are bull markets and primary down trends are bear markets — these are marked by peaks and troughs in price charts. Within these broader trends, there are secondary (minor) countertrends called corrections, which can retrace anywhere from 33% to 67% percent of the primary trend’s movement. Of course, no one ever knows in advance how long trends will last (that’s a key principle of the Dow theory). And since market prices fluctuate from day to day, it’s dangerous to make too much out of a single day’s movement.
  • Primary trends can’t be manipulated. While it may be possible for private interests to manipulate the price of one security for a relatively short period of time, the Dow theory holds that the primary trend in the stock market is driven by forces much bigger than any single individual, cartel, breaking news, or rumor.
  • The stock indexes reflect all available information. The Dow theory believes that everything there is to know about a stock and the economy at a given moment is factored into the prices of stocks. This include hopes, fears, and expectations of such factors as interest rates, earnings, revenue, and product initiatives. Unexpected events can occur, but usually they affect the short-term trend, creating what are called reaction rallies. These soon lose steam and the primary trend resumes.


Three Primary Trend Phases

According to the Dow theory, major trends consist of three phases of varying length:

Stage 1: Accumulation or distribution. In this phase, the smart money — typically large institutional investors like investment banks, pension funds, and mutual funds — start major buying or selling programs. Initially, this looks like a secondary countertrend, but trading volume on the major exchanges noticeably increases on up days, while volume tends to be lighter on down days. In a bull market, stocks are cheap, but no one other than value investors seems to buy them. In a bear market, there’s a high level of enthusiasm for stocks, and few people believe the bull market is over.

Stage 2: The big move. In this phase, there are many more days in which the indexes move in the direction of the primary trend than in the opposite direction. In bull markets, there are strings of up days, followed by shorter strings of down days, reflecting the spread of enthusiasm for stocks. In bear markets, the opposite occurs, as anxiety and pessimism mounts. The result is a significant, long-term increase (bull markets) or decrease (bear markets) in the market averages.

Stage 3: Excess. The final phase of a primary trend is marked by extremely high levels of emotion — enthusiasm in bull markets and pessimism in bear markets — which are signs that the primary trend is about to change. These extremes can be seen in the behavior of individual investors: in bull markets, even the most conservative investors are buying stocks. On the other hand, in the excess stage of a bear market, everyone is concerned about safety of principal, while those who bought stocks at high prices have finally given up and sold at a loss.


The Indexes Confirm the New Trend

For Charles Dow, the primary trend was reflected in the Dow Jones Industrial Average, which today comprises 30 stocks. But Dow also looked to another index to confirm the emergence of a new trend. In his day, that was the Dow Railroad Index. Today, it’s the Dow Transportation Index of 20 companies engaged in the shipping and transportation of manufactured goods, including marine transport, railroads, and trucking. The idea was a true change in the trend of business activity in the big manufacturing firms would show up in business for the companies that move the goods they make.

For the second index to confirm the first, the Dow theory looks for both averages to be moving in the same direction. New highs or lows in one index are accompanied by highs or lows at the same time or shortly thereafter in the other.

The Dow theory isn’t intended to help short-term traders. What it’s designed to do is tip off long-term investors to changes in the trend, so they can shift their money from stocks to another asset class, like bonds or cash, during a full business cycle.


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