Dow Theory

What Is Dow Theory?

The Dow Theory is a technical analysis concept that adherents believe can signal whether the stock market is headed upward ("bullish") or downward ("bearish").

The idea was developed in the late 19th century by Charles Dow. He was the founder of the Wall Street Journal and co-founder of its then parent company, Dow Jones & Company, as well as the creator of the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Index (originally known as the Rail index). Dow is also one of the pioneers of technical analysis, which is a study of patterns in the way a market or individual security has traded in the past in order to try to estimate how it will move in the future.

After years of studying the market prior to his death in 1902, Dow theorized that when one of those averages moves in a given direction, the other will eventually follow suit. Likewise, the general market will move in that direction. However, if one of the averages diverges from the other one, that could signal that the market is about to reverse course.

The thinking behind the theory is based on the logic that industrial companies make goods and transportation companies ship them. If the two indexes move higher relatively in tandem, that's a bullish signal. However, if one average moves higher while the other fails to follow, that could be a bearish signal.

Although Dow is credited with developing the Dow Theory, it was later refined by S.A. Nelson and William Hamilton. It was even further refined by Robert Rhea, who incorporated the previous work into his 1932 book, The Dow Theory.[1]

By understanding the Dow Theory, those who follow it believe they can spot market trends in order to make more informed decisions.

Summary

The Dow Theory is a technical analysis concept that adherents believe can signal whether the stock market is headed upward or downward based on the correlation between the DJIA and the Dow Jones Transportation Index. The idea was developed in the late 19th century by Charles Dow, the founder of the Wall Street Journal and creator of the DJIA, who was also one of the pioneers of technical analysis.

References

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