Complete Guide to Dow Theory

What good is a leaning tower?

You might say none. A spire is supposed to be tall, straight, stable, visible, and provide visibility. Or you might think of the famous Leaning Tower of Pisa and say that it is far from useless. The answer would truly be somewhere in between—and largely depends on why the structure is leaning in the first place.

So what makes a structure lean? 🗼

Well, time, and inadequate soil for its foundation. The Leaning Tower of Pisa started construction in 1172 so it’s quite old, and it’s built upon soil that is far too soft to hold it. It would have almost certainly collapsed by now if it weren’t maintained and watched over throughout the years.

To cut to the chase, we’d argue that the Dow theory has quite a few similarities with this famous spire in Tuscany.

It’s a century old and its foundations aren’t perfect, yet it has enjoyed continuous maintenance and it is still very relevant. Not long ago, this limping centenarian made waves with a decisive trading signal, demonstrating its continued importance.

So let’s find out what the Dow theory is—and why it earns such a posh comparison.

What is the Dow Theory? 📚

The work started in 1882 by Edward Jones, Charles Bergstresser, and Charles Dow truly left a monumental mark. We owe the Dow Jones Industrial Average (DJIA), the Dow Jones Transportation Average (DJTA), The Wall Street Journal, and—of course—the Dow theory to this trio.

Charles Dow was the first editor of The Wall Street Journal and the theory named after him could be considered a bit of a passion project—he developed it over 255 editorials. However, his untimely death in 1902 ensured that he would never complete his work on the theory.

In his stead, William Peter Hamilton, Robert Rhea, and E. George Schaefer carried the torch and shaped up the Dow theory to its more final form by the early 1930s. By the 1960s, the theory had some additional touch-ups with books like Richard Russell’s “The Dow Theory Today.”

Okay, enough of the history lesson. What precisely is the Dow theory?

In the most basic of terms, this theory tries to tell whether you are facing a bull or a bear market—or a reversal of either of these. It achieves this by looking—primarily at least—at the DJIA and the DJTA in a belief that:

1. The market is a good representation of the overall state of business conditions in an economy.
2. That an industry boom necessitates a transportation boom—the better the conditions in the economy, the more goods and materials you need moved.

The Dow theory goes into far more detail on how you can predict if the trend is bearish or bullish and so we’ll obviously be delving deep as well.

The 6 Tenets of the Dow Theory 🗃

The Dow theory has six core tenets which will most likely ring some major bells for anyone familiar with technical analysis. It takes into account the performance of big indices as a benchmark, measures volume, tries to differentiate between major and minor trends—as well as retracements and reversals. It seeks confirmation and urges caution.

The Market Discounts All News 📰

One of the primary ideas of the Dow theory is that the prices on the stock market take account of all available information—and are thus a realistic representation of the actual value of a company. This is a postulate shared with the efficient market hypothesis—and one of the primary reasons for the leaning tower analogy as the EMH is somewhat dubious.

This idea that the market is an accurate representation of the state of the economy is a bit of a strange one. Since it insists that the prices are always accurately determined it implies that finding undervalued shares is impossible—which is decisively disproven by the entire career of Warren Buffett, as he made his fortune investing in undervalued stocks including his very famous Berkshire Hathaway.

This postulate would also make finding and shorting overvalued stocks quite impossible. Furthermore, this would mean that there are, and can be, no bubbles.  Both of these notions can be dismissed as we’ve seen a fair share of bubbles over the last hundred years and might be facing a new one stemming from the tech industry—and that is even if you don’t subscribe to the idea of the “everything bubble.”

Shorting is also provenly possible as best highlighted by Michael Burry’s famous big short of the housing market—albeit very dangerous as was very evident at the beginning of 2021 when r/wallstreetbets went after hedge funds trying to profit off of GameStop’s decline.

On the other hand, it can be argued that there is quite a bit of merit to the idea that the market efficiently incorporates all news and information when determining prices. Let’s look at Crocs (CROX) for a second.

While the information supposedly included in the pricing of stocks is usually seen as more conventional—general trends, signals, management successes, and failures, supply chain crises, and so on—the case of Crocs can be seen as the market effectively taking into account a rather new wild card: internet culture.

Crocs did do its best to ride on this rise in interest releasing new models and going into a marketing campaign—launching its first concept store in Europe, for example—but it is hard not to see how neatly the start of the upping of CROX share prices coincides with the popularity of the “crocs stay on during sex” meme.

The Three Types of Market Trends 📂

The second tenet tries to determine the important trends the market is going through. There are the primary, secondary and tertiary—minor—trends. The primary trends are big, domineering, and tend to last for years if not decades. These can be upward or downward and are usually described as a bear or a bull market.

So, the current primary trend is upward as we’ve been facing a bull market for well over a decade—it is generally considered to have started in March 2009. Note however that many would argue that that particular period lasted from 2009 to 2020 and was followed by a very short bear market from March to August 2020.

Bear markets tend to last shorter than bull markets—the longest one going for 61 months and ending in 1942. This muddies the equivalence between these market nicknames and trends of the Dow theory as most bear markets would likely be merely considered secondary trends.

A secondary trend represents a period of price corrections, usually going against the primary movements—the prices go down in an upward market and heighten amidst an overall drop. It tends to be defined as lasting between three weeks and three months.

The secondary trend can be seen as somewhat tricky as it can often be hard to tell whether we are facing a retracement or a reversal.

The minor—or tertiary—trends are days-long unpredictable market movements. They can go in any direction and represent the general tendency of prices to fluctuate somewhat randomly. They don’t really carry any significance except in the shortest of terms and might really affect you only if you are dabbling in day trading.

Primary Trends Have Three Phases 📝

Since the primary trends are the biggest, they are also the most complex. The Dow theory tells us they have three phases: accumulation/distribution, public participation, and excess/panic.

The accumulation/distribution phase can be considered the time of early adopters. This is when the most skilled and clairvoyant investors start buying in a bull or selling in a bear market. 

The public participation phase is when the bulk of active investors catches the primary trend and starts moving assets en masse. This time is also known as the big move and often constitutes the largest part of the lifetime of the primary trend. Noteworthy is that the Dow theory is in many ways designed to get you in on the trades during this phase.

Excess/panic is when the good times become too good or the bad times become too bad. This phase precipitates the reversal as either everyone is jumping on the bandwagon and buying thus driving prices unsustainably high—or the prices are dropping so much that everyone is trying to sell before they lose everything thus making everything starkly undervalued.

Primary Trends Need Confirmation ✅

When the Dow theory was being concocted, the U.S. was a rising industrial power with supply chains stretching most of the North American continent. Thus, Charles Dow figured that a good way of determining the health of the business in the country was twofold—if industrial companies were doing well, so should the transport services, and vice-versa.

Essentially, factories need raw materials to operate and the railways are there to feed the juggernaut. Out of this logic arose the idea of a need for confirmation using the Dow Jones Industrial Average and the Dow Jones Transportation Average.

The world has changed quite a lot since Charles Dow passed away in 1902 and the West has long stopped being a growing industrial hotspot—the USA especially became the true manufacturing juggernaut before turning into a mostly service-based economy.

However, it is not that hard to see that transportation is still key and can serve as a decent benchmark for confirmation of the overall state of the economy. While manufacturing and mining did mostly move to Asia, the products still need to be shifted to the Americas and Europe.

Furthermore, modern supply chains remain world-spanning and you’ll often find tools and devices that have parts produced in China, the U.S., the EU, Vietnam, and a myriad of other countries. Just think of the last time you felt slightly cheated by buying something “made in the United States” only to see “made in China, assembled in the U.S.” on the fine print.

Furthermore, we all got a taste of the importance of goods and materials transportation in early 2021 when the cargo ship Ever Given got stuck for 6 days in the Suez canal costing the world an estimated $59 billion.

The Dow theory puts a lot of emphasis within the DJTA on the railways as they were king at the turn of the 20th century. While we may feel that cargo trains are somewhat outdated now that we have gone through a fifth of the 21st century, they still reign in many ways.

Eurostat shows us that rail transportation in the EU peaked in 2018 at 398.159 billion tonne-kilometers and fell to a measly 366.545 billion tkm in 2020 due to the covid pandemic—which is still more than in 2010.

Volume Must Align With the Primary Trend 🎛

A very cool aspect of the Dow theory is its insistence on confirmation. Both when it comes to the synergy between the DJIA and the DJTA, and also when it comes to the importance of stock volume. As we know, all tools of technical analysis have limitations, and even the best indicators for binary options, forex, and stocks shouldn’t be used alone.

The idea of this tenet is that volume should be greatest with trades aligning with the primary trend. This is to say that if the conclusion is that the market is bullish and going up, the volume should be very big when the prices are rising. Likewise, it should be huge when the prices are decreasing in a bear market.

A low volume accompanying a movement should likely indicate that we are dealing with a secondary or minor trend. Furthermore, if there is significant volume while the prices are going down—people are overwhelmingly selling—during a bull market, it might indicate a trend reversal.

Similarly and for example, low volume while the prices are decreasing in a bear market can indicate a weakening of the primary trend and could herald a reversal. 

The Primary Trend is in Effect Until a Clear Reversal Occurs

The Dow theory acknowledges the difficulties in differentiating between a secondary trend and a new primary trend—a reversal—in its final and perhaps most controversial tenet. Charles Dow believed that there will be fluctuations in the market no matter what. However, he also believed that this kind of instability doesn’t necessarily endanger the primary trend.

Indeed he advocated watchfulness and caution so as not to panic and buy/sell at the slightest disturbance and giving the primary trend the benefit of the doubt that it is going through a retracement rather than a reversal. Thus, a reversal is considered to be happening only once it becomes blindingly obvious.

This is also reflective of a core philosophy of the Dow theory—trends don’t move in straight lines but rather from peak to peak with throughs in between in an uptrend and from low to low with rallies dividing these throughs in a downtrend.

You could consider this to be a major weakness of the Dow theory—and many would agree—but you should remember that no market analysis tool is infallible or fully accurate and to look at all the cornerstone tenets at the very least to get the best possible heads up to what is going on.

Other Dow Theory Characteristics 📃

An important thing to understand about the Dow theory is that it attempts to remove impulsiveness from investing. It is somewhat slow by design and its focus on confirmation and caution is designed to give you trading signals towards the beginning of phase 2 of the primary trend.

Bad From the Beginning? 🤔

This approach made it practically dead on arrival as a study conducted by Alfred Cowles between 1902 and 1929 and published in 1934 concluded that a simple buy-and-hold strategy outperforms the application of the Dow theory by 3,5%. After this publication, most economists simply disregarded the theory for the better part of the century.

The Resurgence of the Dow Theory 📗

In the late 90s, another study came to light with an article in the New York Times about the Dow theory. A study was conducted by William Goetzmann, Stephen Brown, and Alok Kumar of Yale whereby they created a neural network that simulated investments from 1902 to 1998 using the Dow theory.

The reasoning behind this study was an observation that the original investment experiment from 1902 to 1929 generated excess risk-adjusted returns which were disregarded and that the theory was unjustly dismissed.

Indeed, the Yale experiment showed that a Dow theory portfolio performed 2% better than a buy-and-hold strategy over the almost century-long period. Furthermore, they concluded that the Dow theory excels in a bear market and is slightly sub-par in a bull market—which aligns with common sense considering how cautious Charles Dow’s work is.

The Inner Workings 👷‍♂️

It goes without saying that the Dow theory—were it a market indicator—would be considered a lagging indicator. While Robert Rhea did include the trading range into the theory, he kept cautioning against using it to predict a breakout. He simply put it in place in order to make spotting breakouts easier as they occur.

Finally, it is rather important to know how the Dow theory determines trends and reversals. Basically, it looks for highs and lows and when they are reached and overcome. So, let’s look at a bull market situation, to begin with.

Say that stock X has a peak at $100. After a while, it falls to $70 and then starts climbing again. If it goes to, say, $120 it can be concluded that the uptrend is still on. However, if it reaches $90 and stays there for a while before dipping it is a worrying sign for the trends.

If this leads to a new low through $60 it is indeed a time to keep your eyes peeled—the primary trend might be reversing. Similarly, during a downtrend, a through of company Y of $20 followed by a peak of $25 and another low of $15 gives away that the downtrend is strong. On the other hand, if the next drop registers on the stock ticker as a stop at $21 and is followed by a high of $30, it might just be the time to buy.

Lastly, you should remember that the Dow theory only concerns itself with closing prices disregarding everything happening throughout the day. Another thing it mostly disregards is the sideways movements—they are simply seen as periods of consolidation.

Using the Dow Theory for Investing 💰

The Dow theory lends itself well both to holding a long position and to deciding when to terminate that long position by identifying the current major trend. Simply put, if it indicates that the market is entering an uptrend, or that the bull market is further strengthening, you should buy and hold. It tells you the very same thing—just better as the prices are lower—when it showcases a reversal of the primary trend in a bear market.

On the other hand, if it shows a reversal in a bull market it informs you that a long position is likely not a great idea. This way, it can go a long way in enabling you to recession-proof your portfolio especially in conjunction with other metrics that determine risk-adjusted returns like the Sharpe ratio.

On the other hand, the downside of using Charles Dow’s work is that it is somewhat slow to react. Since it is likely to bring you in on the trade sometime during the public participation phase it can’t be relied upon to provide you with the best possible prices.

Dow Theory and Trading Signals 🕵️‍♂️

While it can’t be used to look into the future of stocks, the Dow theory does generate trade signals. When it comes to sell signals, the story would usually follow:

During a bull market, the prices drop and subsequently rise by at least 3% without reaching the previous peak. This creates the conditions for the signals but does not generate them. In order to get the sell signal, the next rally must penetrate the recent low during its next fall. Even then, you get the mark to sell only if these results are corroborated by both the DJIA and the DJTA.

The buy signals of the Dow theory are pretty much an exact mirror image. After the previous through and rally, the prices must dip by at least 3% and maintain above the previous lows on both averages. If the next rally breaks out above the previous one a buy signal is generated.

Who Let the Dogs Out? 🧐

A rather interesting application of the Dow theory comes in the form of the so-called Dogs of the Dow that was first described in a 2006 article in the WSJ. In this strategy, you’d buy shares of 10 blue-chip companies of the Dow Jones Industrial Average with the highest dividend yield. These would usually be companies that have gone through price drops in the previous year as their stock dividends are usually higher.

Subsequently, you’d hold these stocks for a year in order to trigger less punishing taxes on stocks, and sell. Afterward, you could repeat the process for as many years as you’d want and forgo it at any moment. However, you should remember that just like any other, this strategy isn’t bulletproof—the dogs of Dow have both over performances of more than 10% and underperformances of upwards to 7% compared to their benchmark.

Criticisms of the Dow Theory ⚠

There are three main criticisms often leveled at the Dow theory—that it is tardy, that it is outdated, and that the efficient market hypothesis is simply wrong. All three of these have merit. Chiefly perhaps, the Dow theory is in many ways too slow as trading and investing have significantly sped up since the days of Charles Dow.

The Troubles of Old Age 📆

This speedup is mostly due to the modern reality of most trades being executed by lightning-fast computers as opposed to actual human beings. The impact of such swiftness has been dramatically demonstrated twice already. Once in 1987 on the famous Black Monday, and again with the Flash Crash of 2010.

However, especially the Flash Crash—which lasted a stunning 36 minutes—can also be used as an argument in favor of the slow and steady approach and dollar-cost averaging that go so naturally with the Dow theory.

Another area where the age of the Dow theory shows is in its two venerable and old fashion indices—DJIA and DJTA. The Dow Jones Transportation Average can be considered particularly vulnerable as, while heralded as very sensitive, it is also prone to miscarriages and dubiously relevant.

In late 2021 it was reported as rising due to the newest meme stock Avis. On one hand, this certainly casts doubt on the credibility of the index, but on the other, it isn’t like the DJTA was doing poorly before Avis was launched into the stratosphere. In early 2021 the Dow Jones Transportation Average had a record-breaking 11-week winning streak.

Efficient Market Hypothesis and the Dow Theory 📊

The first tenet of the Dow theory mimics very closely one of the core ideas of the EMH—the prices on the stock market are exactly what they should be. There isn’t really much to say here we haven’t said already. The EMH does have some merits and many defenders, but the idea that there are no undervalued, or overvalued stocks, or bubbles for that matter has been thoroughly disproven.

This particular point can be considered the bad leg of the Dow theory but it is worthwhile remembering that it is just that—one leg of a six-legged creature. Furthermore, the most important assumption of this tenet is that the primary trend cannot be manipulated and we’d be inclined to agree that under normal circumstances this is true.

Sure, it is possible to tamper with the pricing of a small number of securities—some would even say that this is becoming widespread with certain billionaires using their investing apps to drive stocks up or down. But, turning a bull market into a bear market through manipulation or vice-versa would be a true feat of strength. Do you have any idea how huge the stock market is?

Conclusion 💭

The Dow theory is very old and it certainly shows. Furthermore, while it may be the parent of modern technical analysis, many would argue that it has been far surpassed by its children. Still, we must remember that its value and workings have been both in the testing tubes and doing fieldwork for over a century and that it is still widely used—to often positive results.

Considering how accessible investing is in the 21st century due to the availability of excellent online stock brokers it is likely that sheer emotions will drive investors more than ever. This has the potential to make the Dow theory truly shine at its—perhaps truest—aim, which is to separate market realities from our own more basic instincts. 

Furthermore, while currently you really don’t need a centenarian metric to tell you we are in a bull market, this is bound to change—nothing lasts forever and the Dow theory might just be the one to confirm to you the turning of the tide. 

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