Introduction – Technical analysis is one of the most widely used methods in analyzing historical price data to arrive at future trends.
Though the concept of technical analysis dates back to the 1740’s when Japanese traders used candlestick chart patterns to predict trends in agro- commodities such as rice, Charles H. Dow is credited with redefining technical analysis by the six tenets he formulated in his “Dow Theory” in the early 1900’s.
Although the Dow Theory was devised to predict trends in the stock markets; its application has wide usage while analyzing various other financial instruments such as forex and commodities, where trend analysis is extremely important.
While analyzing trends using technical analysis, we come across various indicators such as supports and resistances, reversals and continuation chart patterns, overbought and oversold levels; that draw inspiration from what Charles Dow had formulated.
So, knowingly or unknowingly, we are following at- least some of the tenets formulated by Charles Dow when analyzing the financial markets.
Tenets of Dow Theory
Following are the six principles or tenets of the Dow Theory, which were published in a series of Wall Street journal’s, between 1900- 1902 and authored by Charles Dow himself.
1) Prices discount all information
2) The three- trend market
3) The three phases of a primary trend
4) Market indices must confirm each other
5) Volume must confirm the trend
6) Trend remains intact unless clear reversal occurs
The tenets explained
1) Prices discount all information
The basic and the most important theory of Dow suggest all information whether past, current or predicted events are reflected in the price of an index or stock.
Since an index reflects the performance of a country’s economy, the value of an index prices in an event; past, present or future, thereby discounting the information. Any change in the event from the expected lines will have a bearing on the economy and the value of the index adjusts accordingly.
Similarly, stock prices discount information related to a particular company or sector, while foreign exchange or forex prices reflect the current state of an economy of a country in comparison with its counterpart.
2) The three trend market – Comprises of the
a) Primary trend
Are also called the long term trend and usually last from 6 months to a few years. Breakout from a primary trend will result in a trend reversal
b) Secondary trend
Are corrections in a primary trend that last between three and six months. The secondary trend typically moves in the opposite direction of a primary trend and normally corrects between 1/3rd- 2/3rd of the primary trend. The most important feature of a secondary trend is volumes, which tend to decline as long as the trend is in progress.
c) Minor trend
Are small variations in the secondary trend and usually last from a few days to a few weeks. Minor corrections in the secondary trend take place in the direction of the primary trend. Since minor trends follow the direction of the primary trend, volumes tend to be higher than those during the secondary trend.
3) The three phases of a primary trend- Bullish trend
a) Accumulation phase
Is the period where a financial instrument such as an index, stock, currency or commodity has declined considerably and looks attractive to long- term and informed investors, as they perceive the upside potential to be greater than the downside risk. Although the bottom of a primary trend is difficult to identify, it is considered to be the stage where selling has almost ceased and markets look to be consolidating.
The accumulation phase represents the first stage of a reversal as large investments by funds and long- term investors buying into the financial instrument drives its value higher.
b) Participation phase
As the price of a financial instrument gains, it tends to overcome crucial resistance and breakout levels, as economic growth expands and public optimism improves.
As prices breakout of chart patterns, trend followers and analysts begin to participate by buying the financial instrument and suggesting their clients to do the same, leading to a large rally as more participants join in as the trend expands.
c) Distribution phase
This is the last stage in the uptrend where mass hysteria is created and retail investors who missed the first two phases of the trend begin to participate, sending prices higher. It is also the phase where the large investors who entered during the accumulation phase begin to exit. When the primary trend is a bearish trend, the reverse transpires.
4) Market indices must confirm each other
According to the Dow Theory, at-least two market indices that represent the overall business conditions in an economy should confirm the primary trend. Even if one of them confirms a new bearish trend while the other remains in a bullish trend, it is not an indication of the start of a new trend.
When the Dow Theory was published, the two indices that were created to represent the overall business conditions in the US economy were the Dow Jones Industrial Index and the Dow Jones Rail Index.
5) Volume must confirm the trend
Volumes are used as secondary indicators to confirm price movements and should increase when the prices move in the direction of the primary trend and decrease when prices move in the reverse or in the direction of the secondary trend. If volumes increase in the direction of the secondary trend, it is a sign of weakness in the primary trend.
6) Trend remains intact unless clear reversal occurs
The last tenet of the Dow Theory states that the primary trend remains intact as long as a clear reversal can be seen. A reversal will be confirmed once conditions 2, 4 and 5 are met.
