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What is Dow Theory?
It is a theory based on the editorials written by Charles H. Dow, published in The Wall Street Journal. Charles H. Dow is the founder and first editor of this acclaimed financial news journal. He also founded Dow Jones and Company along with Edward Jones and Charles Bergstresser. The theory was developed by William Peter Hamilton, Robert Rhea and E. George Schaefer. The Dow theory explores the analysis between the Dow Jones Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA). It argues if both of these indexes do not reach new highs or lows in lockstep, the stock market trend is not significant enough. If one of these indexes climbs to an immediate high the other is also expected to follow the same trend within a reasonable time period, if it doesn't the market will revert to its former trading level. The the first index reflects the productive capacity and the second reflects the volume of goods distributed; so, an economic trend will be maintained if they rise or fall together. If they do not and move in opposite directions a reversal in the trend is expected.
How Does Dow Theory Work?
Dow theory has several main components. It argues that: Market Discounts - market discounts everything. It operates on the efficient markets hypothesis that assumes asset prices incorporate all available information including earning potential, competitive advantage, management competence. The future events are also discounted as the risk increases. Market Trends - According to this theory, there are three kinds of market trends. The primary trend lasts a year or more, a secondary trend often works against the primary trend and lasts 3 weeks to 3 months, and the minor trends last less than three weeks, these are generally noise. The primary trend has three phases, accumulation phase or distribution phase, public participation phase and excess phase or the panic phase. DJIA and DJTA must confirm one another. The volume must confirm the trend. If the price is moving in the direction of the primary trend, the volume should increase. A trend continues until a reversal happens clearly. The Dow approach considered to be the core of the modern technical analysis.