The Dow Theory – The Six Tenets of the Dow Theory
A theory regarding the movement of stock prices, the Dow Theory is a form of technical stock analysis that is still used today. It is composed from the analysis of 255 editorials appearing in the Wall Street Journal, written by Charles H. Dow, a preeminent economist and founder of the Dow Jones and Company. There are six main tenets that make up this theory, which are worth taking a look at by anyone who wants to understand the stock market. The first is that the market has three movements, including the main movement, medium swing, and short swing movements. These relate to the amount of time that the market spends in each pattern or trend.
The second tenet of the Dow Theory is that all market trends have three phases. This includes the accumulation phase, public participation phase, and distribution phase. The first phase is when professional investors actively buy and sell a stock. This will not greatly impact the price of the stock, because these investors are in the minority. However, as the knowledge of these beginning movements catches on, the public will start to participate and buy the same stocks, entering the second phase. This causes a rapid price change. Finally, the first round of investors distributes their initial holdings, making the largest profit.
Another component, or third tenet, of the Dow Theory is that the stock prices will incorporate any new information as soon as it is public knowledge, meaning that the news affects prices of stocks. The fourth tenet states that stock market averages must be able to confirm one another, meaning that if one stock rises, it is not a trend until other stocks in the same industry start to follow suit. The averages should, as part of the theory, move in the same direction.
The trends that have been suspected are then confirmed, in the fifth tenet of the Dow Theory, by volume. If prices start to move on a low volume, this could be due to one buyer or seller making certain judgments. However, if the changes in price are also accompanied by a high volume of movement, then this means there is a definite trend. Finally, this theory states that once trends have been identified, you must assume that they exist until there are definitive signals to prove that the trend has ended. By understanding these six tenets, you can gain a greater perspective on the stock market and its trends.