What You Should Know About the Dow Theory

The Dow Theory, created by Charles H. Dow, is a collection of theories that come together to form an idea about how financial markets move over time. While it’s most commonly used in technical analysis, long-term investors can use the Dow Theory to help spot buying opportunities and chances to lower their cost basis for particular investments. The Dow Theory has six main parts to it.

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1. The market discounts all assets

One of the underlying assumptions of the Dow Theory is that markets operate efficiently. In other words, all stock prices are based on all available information about the company. A company’s earnings, management, competitive advantages and weakness, and everything else is factored into its price, regardless of whether an individual investor knows any of that information.

The Dow Theory believes that the market has three trends. The primary trend lasts more than a year and is usually categorized as a bull or bear market. Bull markets are periods of stock price increases, and bear markets are periods of stock price drops. The second type of trend happens within the primary, frequently going against it and lasting up to a few months. Think corrections or pullbacks during bull markets or rallies during bear markets. The last trend happens during daily price movements or trends lasting only a couple of weeks.

The third part of the Dow Theory states that you can break down primary trends into three phases. If it’s a bull market, the three phases are:

Accumulation phase
Public participation phase
Excess phase

If it’s a bear market, the three phases are:

Distribution phase
Public participation phase
Panic phase

4. Averages must confirm each other

Dow created two averages — the Dow Jones Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA) — on the idea that one should reflect the state of manufacturing (DIJA) and one should reflect the movement of those products in the economy (DJTA). In the Dow Theory, a rise in one should also be reflected by a rise in the other. In this case, if business conditions are good (shown by a rise in the DIJA), then the transportation index should also benefit from this increase. If not, the trend isn’t sustainable.

In today’s economy, the industries may vary, but the relationship between complementing industries remains the same.

According to the theory, overall volume should increase if the price is moving in the same direction as the primary trend and vice versa. If it’s low volume, that means the trend has a weakness. In a bull market where prices are rising, volume should increase, while falling during secondary corrections or pullbacks. If volume picks up during a pullback, it could mean the trend is reversing, and investors are becoming more bearish.

Outside of the daily fluctuations in stock prices, Dow believed that prices moved in trends. While changes in trends are all but impossible to predict, the Dow Theory takes on the belief that a trend is currently happening unless there’s definite proof of a reversal.

Using the theory to help your long-term goals

Some traders use technical analysis like the Dow Theory exclusively to motivate their trading. Here at The Motley Fool, we prefer a fundamental approach that looks at the underlying business behind each individual stock.

That said, even if you won’t use it for trading, the Dow Theory can be used as a resource to aid your long-term goals — particularly in the breaking down of market trends like bear markets. Understanding the phases of a bear market can help prevent some panic that can come with watching your portfolio drop because it gives you perspective that these trends are not only frequent, but almost inevitable in you invest for long enough.

One of the Dow Theory’s key components is a “panic phase” during bear markets. As a long-term investor, a bear market shouldn’t cause you to panic; you should view it as a chance to set yourself up for the future by grabbing some of your favorite investments at a “discounted” price. Your cost basis is the average price you’ve paid per share of a company or fund. Being able to lower your cost basis during bear markets is great for investors because it increases your profits when you eventually sell the shares in the future.

Use the Dow Theory to identify market trends, but don’t use it to try to time the market. Warren Buffett said it best: “Be fearful when others are greedy, and greedy when others are fearful.”

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