Chapter - 2
Dow Theory
CMT LEVEL - I

Learning Objectives
• History of Dow Theory
•Dow Theory ideal market picture
• Basic Principle of Dow Theory
• Dow Theory Hypothesis
• Schabacker’s Rules
• Criticisms of Dow Theory

History of Dow Theory
•Dow Theory resulted from a series of articles
published by Charles Dow in The Wall Street Journal
between 1900 and 1902.
•Theory itself originally focused on using general stock
market trends as a barometer for general business
conditions
•Dow Theory describes market trends and how they
typically behave.

Dow Theory ideal market picture
• Ideal market picture
consists of an uptrend, top,
downtrend, and bottom,
interspersed with
retracements and
consolidations
• Economic rationale should
be used to explain stock
market action.
• A trend is defined as the
general direction in
which something tends
to move.

Basic Principle of Dow Theory
• The Market Discounts Everything
• There Are Three Primary Kinds of Market Trends
• Primary Trends Have Three Phases
• Indices Must Confirm Each Other
• Volume Must Confirm the Trend
• Trends Persist until a Clear Reversal Occurs

The Market Discounts Everything
• The Dow theory operates on the efficient markets
hypothesis (EMH), which states that asset prices
incorporate all available information.
•Earnings potential, competitive advantage,
management competence—all of these factors and
more are priced into the market
•The only information excluded is that which is
unknowable, such as a massive earthquake.
•Even future events are discounted in the form of risk.

Primary Trends
•The primary trend is the longest of the three trend
types.
•It represents the overall, broad, long-term movement
of security prices.
•The duration of this long-term trend can be several
years.
• Primary Trend may be Uptrend , Down Trend &
Sideways Trend.

Secondary Trends
• DOW compares the intermediate trend to waves that
makeup tides and they represents correction in the
Primary trend.
• An intermediate trend generally lasts for three weeks
to three months.
•These intermediary corrections generally retraces 1/3
or 1/2 or 2/3 of the previous move.

The Minor or Short Term Trend:
•DOW compares the minor or short term trend to
ripples on the waves.
•Minor trend represents fluctuations in the
intermediate trends.
• A Minor trend generally lasts for less than three
weeks.

Three Primary Kinds of Market Trends

Primary Trends Have Three Phases
• Bull Market Phases
a. Accumulation
- Investors “In the Know” are actively buying against public
opinion.
b. Participation (Absorption)
- Increasing Volume.
- More investors get involved.
- Secondary stocks become popular.
c. Final explosive move
- Excessive speculation and public elation.
- Buying becomes indiscriminate. Investors borrow to buy stocks.

Primary Trends Have Three Phases
• Bear Market Phases
a. Distribution
- Investors “In the Know” are actively selling into the public elation.
b. Panic
- Prices decline faster than anytime in the Bull market rise.
Everyone wants to liquidate . Borrowers have no options but to sell.
c. Lack of Interest
- Investors do not want to experience that again. All stocks are
undervalued. All news is negative and pessimism prevails

Primary Trends Have Three Phases

Indices Must Confirm Each Other
• For a trend to be established, Dow postulated indices
or market averages must confirm each other.
•If one index, such as the Dow Jones Industrial Average,
is confirming a new primary uptrend, but Dow Jones
Transportation Average (DJTA) index remains in a
primary downward trend, traders should not assume
that a new trend has begun.
•If asset prices were rising but the railroads were
suffering, the trend would likely not be sustainable.

Volume Must Confirm the Trend
• Volume should increase if the price is moving in the
direction of the primary trend and decrease if it is
moving against it.
•Low volume signals a weakness in the trend.
•For example, in a bull market, the volume should
increase as the price is rising, and fall during secondary
pullbacks.
•If in this example the volume picks up during a
pullback, it could be a sign that the trend is reversing
as more market participants turn bearish.

Volume Must Confirm the Trend

Trends Persist until a Clear Reversal Occurs
• Reversals in primary trends can be confused with
secondary trends.
•It is difficult to determine whether an upswing in a
bear market is a reversal or a short-lived rally to be
followed by still lower lows
•The Dow theory advocates caution, insisting that a
possible reversal be confirmed.

Trends Persist until a Clear Reversal Occurs
• Reversals in primary trends can be confused with
secondary trends.
•It is difficult to determine whether an upswing in a
bear market is a reversal or a short-lived rally to be
followed by still lower lows
•The Dow theory advocates caution, insisting that a
possible reversal be confirmed.

Trends Persist until a Clear Reversal Occurs

Dow Theory Secondary Consideration

Dow Theory Hypothesis
• The primary trend is inviolate.
- Lots of manipulation was going on.
- Dow theorized that the effect was in the shorter terms.
- Primary trends could not be manipulated.
•Dow Theory is not infallible.
- Dow, Hamilton & Rhea knew that this was not a “magic”
formula.
- They believed that study of the indices would reveal the
probability of the market continuing or reversing.

Dow Theory Hypothesis
•The averages discount everything.
- Investors only studied individual stocks.
- Dow suggested that the Indices foretold the shape of the
industry.
- This was beneficial in understanding the health of the
economy.
- All of Wall St’s knowledge is represented in the price
of the averages.
From this the Dow Theory Tenets were derived.

Schabacker's Rules
• End Of Bull Market
1.Trading volume increases sharply
2.Popular stocks advance significantly while some
other companies collapse.
3.Interest rates are high
4.Stocks become popular topic of conversation.
5.Warnings about an overheated stock market
appear on the news.

Schabacker's Rules
End Of Bear Market
1.Trading volume is low
2.Commodity prices are declined
3.Interest rates have declined
4.Corporate earnings are low
5.Stock prices have been steadily declining and bad news is
everywhere

Dow Theory Criticisms
• One of the criticisms is that following the theory will result
in an investors acting after rather than before or at market
tops and bottoms.
•With Dow Theory, there is an inevitable lag between the
actual turn in the primary trend and the recognition of the
change in trend.
•The theory does not recognize a turn until long after it has
occurred and has been confirmed.
•Different trends are not strictly defined.
•Often the interpretation of price swings is difficult to assign
to a specific trend type.