The Dow Theory is the best known method of determining the major trends in the stock market. It also determines the type of trend, such as bull or bear.
Dow Theory is an excellent tool for use by long-term investors. Martin Pring illustrated its usefulness more than two decades ago:
Starting in 1897, an investor who purchased the stocks in the Dow Jones Industrial Average (DJIA) following each Dow theory buy signal, liquidated the position on sell signals, and reinvested the money at the next buy signal, would have seen the original investment of $44 in 1897 grow to about $51,268 by January 1990. If instead the investor had held on to the original $44 investment throughout this period, the investment would also have grown, but only to about $2,500.
[Pring, M. J., Technical Analysis Explained, McGraw-Hill, New York, 1991, p.31.]
Pring goes on to point out that even after transaction costs and taxes, the results would be far superior to a buy-and-hold strategy. Of course, given the bull market that followed 1991, the statistics would have been even more impressive.
Charles Dow was the son of a farmer. He was born in Sterling, Connecticut, in 1851.
His father died when he was six. He never finished high school, having to work as a labourer to help support his family.
In later life Dow became a journalist. It is believed he started his journalism career covering the city beat for the Springfield Daily Republican in 1872. He subsequently worked for other papers, including a position in 1879 reporting on a mining boom in Leadville, Colorado.
In 1880 Dow became a reporter in New York City, and later accepted a position with the Kiernan News Agency. A colleague at the News Agency was Edward Jones.
Dow and Jones resigned their positions at the Kiernan News Agency and formed Dow Jones and Company, with Charles Bergstresser, in 1882. Jones left the company in 1899.
In 1883 Dow and Jones and Company commenced printing a daily newsletter, the Customer’s Afternoon Letter. This two-page publication was considered very radical at the time. It published stock prices and company balance sheet information that previously had only been available to ‘insiders’. It was not until 1934 that the Securities Act required companies to file quarterly and annual reports in order to keep the investing public informed.
Dow Jones and Company published the first index that was designed to be representative of the movements of the stocks on the Wall Street stock exchange. This was called the Dow Jones Index.
The Customer’s Afternoon Letter became The Wall Street Journal in 1889, the United States’ best-known financial news service at that time. Dow was its first editor and remained editor until his death in 1902.
Dow was a member of the New York Stock Exchange from December 1885 to April 1891.
The Dow Indices
The first index, the Dow Jones Index created in 1884, contained eleven stocks. These included railroad stocks (nine), a communications company and a steamship company. The stocks were chosen because they were key growth stocks. The stocks were Chicago & North Western, D. L. & W., Lake Shore, New York Central, St. Paul, Northern Pacific pfd, Union Pacific, Missouri Pacific, Louisville & Nashville, Pacific Mail (steamship), Western Union (communications).
In 1896 Dow removed the railroad stocks from the Index and created two separate averages – the Dow Jones Industrial Average (DJIA) and the Dow Jones Railroad Average. The Dow Jones Railroad Average became the Dow Jones Transportation Average (DJTA), after the addition of air and truck transport stocks in 1970.
The Dow Jones Utilities Average (DJUA) was first compiled in 1929.
The Dow Jones Industrial Average commenced with 12 stocks in 1886. It was expanded to 20 stocks in 1916 and to 30 stocks in 1928. Today the Dow Jones Industrial Average contains 30 stocks, the Dow Jones Transportation Average contains 20, and the Dow Jones Utility Average 15. General Electric is the only stock of the original 12 to survive until today, despite being removed and replaced twice.
The Dow Jones Index was a simple average – calculated by adding the price of the eleven stocks together, and dividing the total by eleven. After 1928, the calculation became more complicated with the use of the ‘Dow Divisor’, a number that takes into account stock splits. Norman Fosback explains its use as follows:
Assume that the prices of the 30 stocks summed to $3,000. Then the 30-stock average would be $3,000 divided by 30, or 100.00. If one of the 30 stocks was quoted at $200, but then split two-for-one so that its price fell to $100, the sum of the prices would be only $2,900. To maintain the Average at its actual level of 100.00, the divisor of the average is systematically altered. Since $2,900 divided by 100.00 equals 29, the new divisor is set at 29, down from 30, in effect preserving the average price at $100 ($2,900 divided by 29 still equals 100.00).
[Fosback, N., Stock Market Logic, IER, Fort Lauderdale, 1986.]
As of August 17, 2001, the divisor values of the DJIA, DJTA and DJUA stood at 0.14452124, 0.20545179 and 1.6041980, respectively.
The Development of Dow Theory
William Peter Hamilton was a reporter who worked closely with Dow. He edited The Wall Street Journal until his death in 1929. Around the 1900s, people tended to assume that a stock’s price fluctuated in accordance with the specific fundamentals of the stock itself and the attitude of the traders who traded the stock. This was, and is, a reasonable assumption.
Between 1900 and 1902, Dow noted in The Wall Street Journal editorials the fact that although each stock moved independently, there was also an underlying trend of the market as a whole. Dow wrote very little about his theories and did not attempt to use his knowledge of his theory to publish market forecasts in his editorials.
In 1902 Dow’s friend, S. A. Nelson, wrote The ABC of Stock Speculation. Nelson’s book was the first explanation of the potential application of Dow’s theories.
Hamilton, an Englishman by birth, as editor of The Wall Street Journal, published editorials that he called ‘The Price Movement’. He believed that the stock market was an indictor of the profitability of business, which in turn could be used to forecast its own likely trend.
Between 1902 and 1929, Hamilton improved Dow’s methods. His accurate editorial forecasts in The Wall Street Journal established the value of Dow Theory, as it had become known, in forecasting stock market price movements and business trends.
In 1922, Hamilton published The Stock Market Barometer: A Study of its Forecast Value Based on Charles H. Dow’s Theory of the Price Movement. This classic book expanded on what Hamilton had written in his editorials. Hamilton died in 1929.
In 1932, Robert Rhea wrote his classic, The Dow Theory, based on his study and synthesis of the 252 editorials written by Dow and Hamilton. This book has a 139-page Appendix, in which the editorials of William Hamilton are reproduced.
What is Dow Theory
Dow Theory is based on the assumption that the averages discount everything. As Robert Rhea explains:
The fluctuations of the daily closing prices of the Dow-Jones rail and industrial averages afford a composite index of all hopes, disappointments and knowledge of everyone who knows anything of financial matters, and for that reason the effects of coming events (excluding acts of God) are always properly anticipated in their movement. The averages quickly appraise such calamities as fires and earthquakes.
[Rhea, R., The Dow Theory, Barron’s, New York, 1932, p19.]
Dow Theory considers that market movements can be described in terms of the primary trend (the bull and bear markets which are measured in years), the secondary movements (which are measured in weeks to months) and daily fluctuations, which are of little significance. Secondary movements correct moves in the primary trend.
Dow also addressed the issue of market phases in primary bull and bear markets. He divided a primary bull market into three phases:
A primary bull market is a broad upward movement, interrupted by secondary reactions, and averaging longer than two years. During this time stock prices advance because of a demand created by both investment and speculative buying caused by improving business conditions and increased speculative activity. There are three phases of a bull period: the first is represented by reviving confidence in the future of business; the second is the response of stock prices to the known improvement in corporation earnings, and the third is the period when speculation is rampant and inflation apparent – a period when stocks are advanced on hopes and expectations.
[Rhea, R., The Dow Theory, Barron’s, New York, 1932, p13.]
He also divided a primary bear market into three phases:
A primary bear market is the long downward movement interrupted by important rallies. It is caused by various economic ills and does not terminate until stock prices have thoroughly discounted the worst that is apt to occur. There are three principle phases of a bear market: the first represents the abandonment of the hopes upon which stocks were purchased at inflated prices; the second reflects selling due to decreased business and earnings, and the third is caused by distress selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets.
[Rhea, R., The Dow Theory, Barron’s, New York, 1932, p13.]
According to Dow Theory, a bull trend is defined as a series of higher peaks and higher troughs. A bear trend is defined as a series of lower peaks and lower troughs. For Dow Theory to confirm a bull market, both the Dow Jones Industrial Average and the Dow Jones Transportation Average must be in bull trends. For Dow Theory to confirm a bear market, both the Dow Jones Industrial Average and the Dow Jones Transportation Average must be in bear trends. The closer these confirmations occur in time, the more significant the resulting move is likely to be.
Dow Theory also discusses accumulation and distribution. If a market moves within a range of about 5 per cent for several weeks or more, accumulation or distribution is taking place. If both averages subsequently break out above this ‘line’, the sideways movement was accumulation and prices should continue to rise. If both averages subsequently break out below this ‘line’, the sideways movement was distribution, and prices should continue to fall. A break by only one average is inconclusive.