Technical analysis in finance is used to forecast what direction prices will take in the light of past market data. Dow Theory is a form of technical analysis that pertains to the stock market, and is used to forecast share prices. The theory which was developed by Charles Dow has been around for over a century, and after his death, was further worked upon by William Peter Hamilton, Robert Rhea, and E. George Schaefer. The Theory attests to the fact that the stock market behaves today as it did when the Theory was originally developed.
The successful application of Dow Theory depends on the acceptance of certain assumptions, the first of which is that the primary trend, that is, the major market trend of prices cannot be manipulated. Second, we assume that all available information is reflected in the market through market prices. The successful application of Dow Theory depends upon our objectivity. It is a set of principles developed to assist investors and traders in the market, and is not meant for short term trading.
Dow Theory uses trend analysis to determine which way the market is headed. Three types of trends can be identified: the primary trend is the major market trend and can last for a few months, or can even stretch out to last for a period of a few years. Then there are the secondary trends which last for a shorter time period, and run against the primary trends. Secondary trends are reactionary in nature. Lastly we have daily fluctuations; however, due to the extreme capriciousness of stock prices on a day to day basis, the value of Dow Theory to forecast daily fluctuation in stock prices is at best limited and too much emphasis on this could possibly lead to erroneous results and losses.
Both bull (where there is a sustained increase in prices), and bear (where there is a sustained decrease in prices) markets have three stages associated with them. The first stage of a primary bull market is that of accumulation. This is the stage in which the market begins to boom, but widespread pessimism still prevails. The second stage is normally the longest stage, and is also the stage which sees the greatest increase in prices. Business conditions improve, stock valuations increase, and people start to become confident in the market. The last stage of the bull market is marked by excessive speculation, and inflationary pressures. There is soaring confidence in the market. This stage mirrors the first stage of the bear market.
The primary bear market starts off with distribution. As people realize that they thought of business conditions as better off than they actually are they begin to sell stocks; market decline begins to take hold. In the second stage of the bear market, as with that of the bull market, there is a large change in price. In this case however, prices plummet. Business conditions start to worsen as earnings estimates are reduced, and revenues fall. The last stage is characterized by general despair, and wide-spread pessimism; valuations are low, but people still seek to sell their stocks. Once the market has reached its lowest point, the cycle begins again.
Peak and trough analysis may be used to identify the trend. An upward trend is characterized by prices that form rising peaks, and vice versa. Whilst identifying trend it is important to make sure that the Dow Jones averages are in agreement. Lastly, volume must also confirm the trend suggested by the indexes. It is used as a secondary indicator of the primary trend in prices.
Dow Theory has survived through all these years, but not without its criticism. It is criticized as being slow, and as sometimes being out dated, and also as an inaccurate reflection of the economy. Whilst using Dow Theory however, it is important to keep in mind that the Theory is only a tool for market analysis, and can serve only as a starting point, and not as the final word.