The Basic Tenets of Dow Theory

Dow Theory forms the cornerstone of the study of technical analysis, even in the face of today’s sophisticated computer technology, and the proliferation of newer and supposedly better technical indicators.

Basic Tenets

1. The averages discount everything.

The sum and tendency of the transactions of the Stock Exchange represent the sum of all Wall Street’s knowledge of the past, immediate and remote, applied to the discounting of the future.

2. The market has three trends.

Dow defined an uptrend as a situation in which each successive rally closes higher than the previous rally high, and each successive rally low also closes higher than the previous rally low.

Dow considered a trend to have three parts, primary, secondary, and minor, which he compared to the tide, waves, and ripples of the sea. The primary trend represents the tide, the secondary or intermediate trend represents the waves that make up the tide, and the minor trends behave like ripples on the waves.

3. Major trends have three phases.

Major trends usually take place in three distinct phases: an accumulation phase, a public participaton phase, and a distribution phase. The accumulation phase represents informed buying by the most astute investors. The public participation phase occurs when prices begin to advance rapidly and business news improves. The distribution phase takes place when newspapers begin to print increasingly bullish stories; when economic news is better than ever; and when speculative volume and public participation increase.

4. The averages must confirm each other.

In referring to the Industrial and Rail Averages, Dow meant that no important bull or bear market signal could take place unless both averages gave the same signal, thus confirming each other. Both averages must exceed a previous secondary peak to confirm the inception or continuation of a bull market.

5. Volume must confirm the trend.

Volume is recognized as a secondary but imprortant factor in confirming price signals. Volume should expand or increase in the direction of the major trend. In a major uptrend, volume would then increase as prices move higher, and diminish as prices fall. In a downtrend, volume should increase as prices drop and diminish as they rally.

6. A trend assumed to be in effect until it gives definite signals that it has reversed.

This tenet forms much of the foundation of modern trend-following approaches. a number of technical tools are available to traders to assist in the difficult task of spotting reversal signals, including the study of support and resistance levels, price patterns, trendlines, and moving averages.