10.3 What is Dow Theory?
According to the Dow Theory, the market (which means price of stocks in general) has three simultaneous movements. The most important movement is called the primary trend, which is a broad upward or downward movement lasting usually for a few years.The upward movement is called a bull market and the downward movement a bear market.
A secondary movement is called technical correction. This is much shorter in duration and is opposite in direction to the primary trend. Actually, a technical correction is the intermediate reaction to the primary trend, namely, a sudden decline in a bull market or a sudden rise in a bear market.
Such interruptions can last for three weeks to three months and usually retraces one-third to two thirds of the previous advance in a bull market or one third to two-thirds of the previous decline in a bear market. Quite often, you notice during a bull phase of the stock market, the soaring prices suddenly drop to a low level and continue for some time till they pick up again, and the reverse also happens in a bear market when suddenly the BSE index shoots up for some period. This occurs because the bull operators who jack up the price in a bull market need to disinvest a part of their portfolio from time to time to ensure liquidity. Similarly, bear operators, who sell without possessing shares from time to time, buy a part of the shares for delivery – called short covering – leading to a technical correction in a bear market. In addition, there is a third movement due to daily fluctuation, which is not considered important by the Dow Theory.
How Does The Dow Theory Predict Future Market Movement?
If you see a plot of any market index, say BSE Sensex, over a period of time, you can see a wave pattern resulting in a number of ups and downs which we shall call ‘peaks’ and ‘bottoms’. As mentioned, the Dow Theory seeks to detect the primary trend and assumes that stock prices have a momentum of their own by which prices tend to maintain the same direction, once they achieve a primary trend. Now pushing the concept further, the Dow Theory says that if the market index movement is such that all successive peaks are ascending and all successive bottoms are ascending, then there exists a primary up trend. Conversely, if the successive peaks and successive bottoms show a downward slide, it signals a major downtrend.
Dow constructed two market indices, DJIA and DJTA. If both show a primary up trend, it signals a bull market. Similarly, a downtrend in both indices can be interpreted as a signal of a bear market. The Dow Theory gave a signal about the end of a big bull market in the US in October 1929, and in 1933, the Dow Theory also predicted the end of a long bear market. However, the shortcoming of Dow Theory is that it takes time in identifying the major trend because the two averages must be confirmed. It can only tell you the direction of a major trend but not about the technical correction or the stocks you may buy or sell.