Dow theory

Stock price movements- something that has always been under speculation for various reasons. Every thinker and finance expert has its own views and theories that elaborated on the working of the stock market. One such theory is the Dow theory. The theory was derived from 255 Wall Street Journal editorials written by Charles H. Dow (1851-1902), journalist, founder and first editor of the Wall Street Journal and co-founder of Dow Jones and Company. The theory lays down some basic tenets which are as follows.

Tenet 1

Markets are dynamic and there are bound to be movements in the market that ultimately cause a shift in stock values. The Dow theory classifies these movements in the market into three basic categories.

1) The main movement. This one is considered as the major trend. Usually this trend may last for less than a year and go up to several years. This reaction can be either bullish or bearish.

2) The medium swing. Also known as secondary or intermediate reaction, this one usually lasts from ten days to three months.

3) The short swing. These are minor movements that usually vary with opinions. They may exist for tenure as short as some hours or at the max last for a couple of months.

Tenet 2

As per this tenet every market trend undergoes three phases.

Phase 1. This is the accumulation phase when a certain set of investor purchases their stock against the general opinion of the market. Since the stock purchasing investors exist in a minority, there is little or no change in the stock price.

Phase 2. This trend initiated by a few investors finally catches up in the market.

Phase 3. More technically oriented investors and other trend followers began to participate. This phase stretches till the time rampant speculation occurs.

Tenet 3

The stock market gulps down information as soon as it is released. This is evident in the changes in stock market prices.

Tenet 4

When this theory was formulated, US were a growing industrial power. At that time population was rather concentrated but factories were scattered throughout the country. To make the goods available for sale, these factories shipped the goods via railroads. Since manufacturing companies and rail companies both accounted for making the products available for sale, Dow calculated stock index based on the two.

As per this tenet of Dow theory, an increase in profits meant an increase in production. This leads to a further implication that if the manufacturers were producing more the railroads should be shipping more. So if an investor was to get an idea of the health of manufacturers, he was supposed to consider the performance of railroads too.

Tenet 5

This tenet of the Dow's theory suggested a relationship between volume and price trends. A price change that is accompanied with a slow volume may be a result of several factors. For instance an aggressive seller in the market would be the reason for a slow volume in the price change. However if the price changes were higher in volume, it would indicate towards a particular trend. This implies that several investors were active in a particular security.

Tenet 6

If there is a particular trend in the market, it will continue to exist regardless of contradictory opinions and other influencing factors known as 'market noise'. Initially it may happen that the market might move in a direction opposite to the trend. But very soon it shall resume the trend and actively participate in the same. So when there is a reversal in the market, there is always a place of doubt, as you never know whether these reversals are temporary or are pointing towards a permanent move.