Dow Theory Explained

The theory that any major stock market trend must occur both in the Dow Jones Industrial Average and the Dow Jones Transportation Average; both indices must reach either new highs or lows, otherwise the market will fall back to its previous trading range. Dow Theory is based on a technical analysis theory pioneered by Charles Dow, one of the founders of The Wall Street Journal and Dow Jones & Co.

Dow Theory has its origins in the writings of Charles Dow -- founder of the Wall Street Journal and creator of the Dow Jones Industrial Average. His Journal editorials pioneered technical analysis. On his death in 1902, William Hamilton continued Dow's work, writing editorials of his own until 1929. Robert Rhea then collected the work of both of these men and used it as a basis to publish The Dow Theory in 1932.

Charles Dow developed the Dow theory from his analysis of market price action in the late 19th century. Until his death in 1902, Dow was part owner as well as editor of The Wall Street Journal. Although he never wrote a book on the subject, he did write some editorials that reflected his views on speculation and the role of the rail and industrial averages.

Even though Charles Dow is credited with developing the Dow theory, it was S.A. Nelson and William Hamilton who later refined the theory into what it is today. Nelson wrote The ABC of Stock Speculation and was the first to actually use the term "Dow theory." Hamilton further refined the theory through a series of articles in The Wall Street Journal from 1902 to 1929. Hamilton also wrote The Stock Market Barometer in 1922, which sought to explain the theory in detail.

Another feature in Dow theory is the idea of line ranges, also referred to as trading ranges in other areas of technical analysis. These periods of sideways (or horizontal) price movements are seen as a period of consolidation, and traders should wait for the price movement to break the trend line before coming to a conclusion on which way the market is headed. For example, if the price were to move above the line, it's likely that the market will trend up.

The initial form of technical analysis is referred to as Dow theory. This theory was developed by Charles Dow, founder of the Dow Jones financial news service and the initial editor of the Wall Street Journal. Dow Theory is predicated on the idea that a market has discernible cycles. The cycles average four years, but may vary in length (2-10yrs). Each cycle is divided into primary, secondary and minor trends. 30

First, let's talk about Charles Dow, a man who, by any reckoning, must be considered a brilliant market observer and theorist. Dow started his career as an investigative reporter, specializing in business and finance. In 1885 (and few people are aware of this), Dow became a member of the New York Stock Exchange, and this provided him with an intimate knowledge of how the market works. In 1889 Dow began publishing a little newspaper which he called The Wall Street Journal. Between 1899 and 1902 Dow wrote a series of editorials for his Journal, editorials that many consider among the finest ever to come out of Wall Street. Written almost 100 years ago, these editorials are as pertinent and valuable today as they were the day they were written.

William P. Hamilton, Dow's understudy and the fourth editor of the Wall Street Journal, continued Dow's legacy after his death in 1903. The Dow Theory as interpreted by Hamilton forms the basis of all modern technical analysis today. He wrote about the Dow Theory for the Wall Street Journal for more than 20 years.

The impetus for revising the Industrial and Raiload Averages, as opposed staying with one general Dow average, was that they would be inextricably linked together. There is supposed to be a direct correlation between them in order for the Dow Theory to work. Although many modern purveyors have turned his thought into technical gobbledegook, the simple fact is that if Dow were alive today, he probably would reject any attempt to predict the market with his averages as they are now constituted. Dow Theory, as least as far as Dow crafted it to be, has absolutely no contemporary relevance. However, Dow's Averages live on and remain a fixture in the investment world, with the Industrials having become a measure for the market as a whole.

He had two basic topics, the economy and the market, and he tended to view any other subject such as politics through those prisms. These pieces became more substantive as Dow Jones evolved from a bulletined news service into a newspaper publisher, first of the Customers Afternoon Letter in 1883 (basically a compilation of the days "flimsies") and then of The Wall Street Journal, beginning in 1889."

The next great writer in the Dow Theory chain was Robert Rhea. Rhea was a devoted student of Hamilton's, and Rhea adhered closely to Hamilton's version of Dow Theory. Over a period of many years, Rhea codified and refined Dow Theory, always deferring to Hamilton in his explanations.

Elliot Wave theory is an outgrowth of the original technical market analysis of Dow Theory. Elliot Wave theory postulates that the market movements of each cycle are defined and predictable. A bull market is defined by a five wave movement. Bull markets are characterized by three major moves with the trend, interrupted by two secondary style moves against the trend. Bear markets are characterized by a three wave structure, two major moves with the trend and a single secondary move against the trend.

On November 12, 1932, Rhea started a stock market service which he titled, "Dow Theory Comment." The service was successful from the start. Rhea's early letters were written during the depths of the greatest depression in American history, and you can imagine the skepticism with which his almost shocking bullish reports were greeted. Rhea also called the turn (to the downside) in the bear market of 1937, and this feat, even more than his 1932 bull market call, made Rhea a household name on Wall Street.

Many are saying that after the Labor day weekend when volume returns to the market that it will be up up and away. Yet, others proclaim a decline into the fall. If you are interested in a statistical and technical based source that also utilizes Dow theory and provides statistical probabilities as to what should occur, then Cycles News & Views may be for you. The September issue will be available later this weekend and it contains all of the updated statistical probabilities and expectations for the stock market for the rest of 2006 and into 2007. A subscription also includes short-term updates three nights a week.

Schaefer started his career as a stock broker with Goodbody & Co. He spent many years studying the writing of the great Dow Theorists who preceded him. But Schaefer concentrated his studies on the brilliant and seminal writings of Charles Dow. Schaefer was a firm believer in VALUES. One of Schaefer's favorite quotes from Dow was, "An investor who will study values and market conditions, and then exercise enough patience for six men will likely make money in stocks." Dow Theory Explained