Why the Dow Theory is important
One of the components in the Dow Theory is that stock prices reflect all news. The stock market reacts to the fundamental news. As soon as the information is available in the market, the information is reflected in the share prices.
The Dow Theory assumes that when a stock market is entering an uptrend or downtrend, the financial markets should agree with each other. The average of the indexes—like the industrial average or railroads’ average—should confirm each other in the same direction. It means when the economy is improving, the industry’s profit will increase because of the increased consumption.
So, rail transportation would also increase because of the increased consumption. Both of the index averages would be in the same direction. As a result, the stock indexes confirm the trend direction.
The above chart shows volume and stock price movement for Chevron’s (CVX) stock.
When a stock is entering an uptrend or downtrend it should be confirmed by the rise in the stock’s volume. If the stock’s volume is low, the direction of the stock trend can’t be confirmed. When the volume and stock price increase, this indicates more investors are driven by fundamental or psychological factors. It shows that the stock price will increase. This confirms the trend directions.
When market trends reverse after giving strong signals, the stocks will continue to be in an uptrend or downtrend. The stock prices will have a minor correction. The correction doesn’t mean that the trend changed. The stock price declined enough to confirm that the trend changed.
The Dow Theory is useful for understanding technical analysis. It’s also useful for trading strategy. The economy and indexes changed compared to the Dow Theory’s period. The Dow Theory is useful for trend identification. It’s also useful for entry and exit signals.