Dow Theory, created by Charles H. Dow, is a collection of theories that come together to form an idea about how financial markets move over time. While it is most commonly used in technical analysis, long-term investors can use the Dow Theory to help spot buying opportunities and possibilities to lower their cost base for particular investments. The Dow Theory has six main parts.
1. The market discounts all assets
One of the underlying assumptions of the Dow Theory is that markets operate efficiently. In other words, all stock prices are based on all available information about the company. A company’s earnings, management, competitive advantages and weaknesses, and everything else, are factored into its price, regardless of whether or not an individual investor knows that information.
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2. The market has three main trends
The Dow Theory believes that the market has three trends. The main trend lasts for more than a year and is usually classified as a bull or bear market. Bull markets are periods of rising stock prices and bear markets are periods of falling stock prices. The second type of trend occurs within the primary, often going against it and lasting up to a few months. Think of corrections or pullbacks during bull markets or rallies during bear markets. The latest trend occurs during daily price movements or trends that last only a couple of weeks.
3. Primary trends can be broken down
The third part of the Dow Theory states that you can divide primary trends into three phases. If it is a bull market, the three phases are:
- accumulation phase
- Public Participation Phase
- phase excess
If it is a bear market, the three phases are:
- Distribution phase
- Public Participation Phase
- panic phase
4. Averages must confirm each other
Dow created two averages: the Dow Jones Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA) — on the idea that one should reflect the state of manufacturing (DIJA) and one should reflect the movement of those products in the economy (DJTA). In the Dow Theory, an increase in one should also be reflected in an increase in the other. In this case, if business conditions are good (reflected in an increase in the DIJA), then the transportation index should also benefit from this increase. If not, the trend is not sustainable.
In today’s economy, industries may vary, but the relationship between complementary industries remains the same.
5. Trends are confirmed by volume
According to the theory, the overall volume should increase if the price moves in the same direction as the main trend and vice versa. If it’s low volume, that means the trend has a weakness. In a bull market where prices are rising, volume should increase, while falling during secondary corrections or pullbacks. If the volume increases during a pullback, it could mean that the trend is reversing and investors are becoming more bearish.
6. Trends continue unless a definitive reversal occurs
Outside of the daily fluctuations in stock prices, Dow believed that prices moved according to trends. While changes in trends are almost impossible to predict, Dow Theory assumes the belief that a trend is currently occurring unless there is definite proof of a reversal.
Using theory to help your long-term goals
Some traders use technical analysis like the Dow Theory exclusively to motivate their trades. Here at The Motley Fool, we prefer a fundamental approach that looks at the underlying business behind each individual stock.
That said, even if you won’t be using it to trade, Dow Theory can be used as a resource to help you with your long-term goals, particularly in breaking down market trends such as bear markets. Understanding the phases of a bear market can help prevent the panic that can come from seeing your portfolio fall because it gives you insight that these trends are not only common, but almost inevitable if you invest long enough.
One of the key components of the Dow Theory is a “panic phase” during bear markets. As a long-term investor, a bear market shouldn’t cause you to panic; You should see it as an opportunity to prepare for the future by taking some of your favorite investments at a “discounted” price. Your cost basis is the average price you’ve paid per share of a company or fund. Being able to reduce your cost base during bear markets is great for investors because it increases your profits when you eventually sell the stock in the future.
Use the Dow Theory to identify market trends, but don’t use it to try to time the market. Warren Buffett said it best: “Be fearful when others are greedy, and be greedy when others are fearful.”
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