What’s the Dow Theory?

The Dow Theory

The Dow Theory was developed by Charles Dow. It identifies and signals the change in stock market trends. It’s useful for trading and investing.

The Dow Theory has six components:

  1. The markets have three basic movements.
  2. The market trends have three phases.
  3. Stock prices reflect all news.
  4. Financial market indexes should agree with each other.
  5. Market trends should be confirmed by volume.
  6. Market trends reverse after giving strong signals.

The markets have three basic movements. The movements include:

  1. Primary trend
  2. Secondary trend
  3. Minor trend

The major market movement is called as the primary trend. The medium movement is called the secondary trend. The smallest movements are called the minor trend. The primary trend can last from many months to many years. The secondary trend ranges from ten days to three months. The minor trend ranges from a few hours to one month.

The market trends have three phases. The phases are:

  1. Accumulation phase
  2. Public participation phase
  3. Distribution or panic phase

All of these phases occur in the uptrend and downtrend.

What’s the Dow Theory?

The above chart shows the three phases of the market trend for Goldman Sachs’ (GS) stock.

In the accumulation phase, investors buy or sell stocks. This accumulation happens during the beginning of an uptrend or downtrend.

In the public participation phase, the fundamental news starts to impact the stock prices. In this phase, more investors participate. They drive the stock price higher in an uptrend and lower in a downtrend. In this phase, there’s volatility in the stock prices. This phase happens in the middle of an uptrend or downtrend.

In the distribution phase, all of the prices have peaked or bottomed. During this phase, more investors sell in an uptrend and buy in a downtrend. There’s consensus in the market that the stock price is trading above or below its fundamental valuation.

The Dow Theory’s concepts will be discussed in the next part of this series.

Applying the Dow Theory

The Dow Theory can be applied to stocks like Chesapeake Energy Corporation (CHK), Cabot Oil & Gas Corporation (COG), Devon Energy Corporation (DVN), and Southwestern Energy (SWN). Many of these stocks are part of energy exchange-traded funds (or ETFs) like the Energy Select SPDR ETF (XLE).