When even the tiniest molecules in the universe follow some pattern, it comes as no surprise that stock markets show some pattern of their own. Much of the idea behind seeking some pattern in stock prices owes its origin to the keen observations made by Charles Dow in his editorials for The Wall Street Journal. We can’t understand how technical analysts seek patterns in price charts without talking about the Dow theory.
Johnny: Let’s cut straight to the chase. Tell me about Charles Dow and his famous Dow theory.
Jinny: We all remember Charles Dow as a co-founder and the first editor of The Wall Street Journal. But beyond the spotlight of the Journal, Dow is also known for his Dow theory, which has become a sort of basic mantra for much of the technical analysis that we see today.
The Dow theory owes its origin to Dow’s editorials that were refined and analysed after his death in 1902 by William Hamilton and some of his other followers such as Samuel Nelson and Robert Rhea, among others. Dow himself never projected his editorials as market theory. But the legacy of his thoughts have continued to exist in the form of the Dow theory for more than 100 years now and with new believers joining, this theory is expected to remain popular for years to come.
Johnny: Interesting thoughts have a life of their own. But what does the Dow theory say?
Jinny: The Dow theory believes that stock market prices follow a trend. Dow, through his observations, arrived at the conclusion that prices move in a pattern. If the market is going through an uptrend, then the prices will continue to rise until the uptrend changes into a downtrend. The evidence of any change in the trend can be gathered by observing price charts.
Illustration: Jayachandran / Mint
In a way, the Dow theory is based on the presumption that stock prices convey everything that is worth knowing about the stock. Be it future earnings or fear of the future or just hope, almost everything is reflected in the current stock price. But the focus of the Dow theory is always on the changes in average price as reflected by some market index.
The Dow theory relies upon the Dow Jones Industrial Average and the Dow Jones Transport Average for its analysis. But the theory should work as well with any other market index. The focus on a market index helps in minimizing discrepancies that might creep in when observing individual securities.
Johnny: How can one know about the current market trend or the overall mood of the market by analysing stock prices?
Jinny: The Dow theory says that three kinds of trends are seen working in the market. The first is the primary trend, which lasts from a few months to many years, and could be either bullish or bearish. Then we have a secondary trend that lasts from a few weeks to some months and that moves in the direction opposite to the direction of the primary trend.
So if the primary trend is bullish, then the secondary trend would come in the form of temporary corrections or fall in prices, and if the primary trend is bearish then the secondary trend would bring a temporary rally or rise in prices. But once the secondary trend is over, the market continues its march in the direction of the primary trend.
Apart from primary and secondary trends, the market also sees day-to-day fluctuations that can last from one day to a week, during which the prices could move either in the direction of the primary trend or in the opposite direction. Interestingly, day-to-day fluctuations don’t have much of a role in the Dow theory. The main focus lies on identifying the primary trend and making investments based on that. Changes in the secondary trend are observed for deciding the direction of the primary trend. You can know about the overall direction of the market by watching both the trends simultaneously.
Johnny: Can you elaborate?
Jinny: When you watch both primary and secondary trends, you would observe something like this: The overall direction of the market over a period of, say, one year or two is decided by the direction of the primary trend, with the secondary trend acting as a temporary pull-back.
So the movement of a stock index would look like someone taking two steps forward and one step backward. In a market trending up, the market rises then falls a bit, then rises once again and reaches a point higher than the previous high.
In a down-trending market, the whole movement is reversed. The market falls then rises a bit, then falls once again to reach a point lower than the previous low.
Johnny: Surely it seems like two steps forward and one step backwards. Some more questions are swinging to and fro in my mind. But let’s keep them for the next week.
Next week: Read about how to identify changes in the primary trend.
What:The editorials of Charles Dow, the co-founder and editor of The Wall Street Journal, became famous as the Dow theory.
How: The Dow theory believes that we can discover the future direction of the market by analysing price charts.
Who: The Dow theory was formulated and made popular by William Hamilton, Samuel Nelson and William Rhea, among others.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org