Definition
Dow Theory is a framework for understanding and predicting market trends, particularly the movements of stock prices, based on the condition that major trends must be confirmed by corresponding movements in the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA). This theory asserts that if one of these indexes reaches a new high or low, the other must follow suit to confirm a significant market trend. If both do not achieve new levels, the market may revert to its former trading range.
Examples
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Bull Market Confirmation: Suppose the DJIA reaches a new high, and shortly afterward, the DJTA also reaches a new high. According to Dow Theory, this simultaneous movement confirms a bullish trend, suggesting that stock prices are likely to continue rising.
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Bear Market Confirmation: If the DJIA falls to a new low and soon after, the DJTA also falls to a new low, Dow Theory would interpret this as confirmation of a bearish trend, indicating that stock prices are likely to continue declining.
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Non-Confirmation: If the DJIA reaches a new high but the DJTA does not, Dow Theory suggests that there is no confirmation of the new high, hinting that the market may fall back to previous levels rather than continuing to rise.
Frequently Asked Questions (FAQs)
What is Dow Theory?
Dow Theory is a theory in technical stock market analysis that suggests a major trend is confirmed only when both the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA) display similar movements, either reaching new highs or new lows simultaneously.
Who developed Dow Theory?
Charles Dow, the co-founder of Dow Jones & Company and the Wall Street Journal, developed Dow Theory. It was further refined by other analysts, including William Hamilton and Robert Rhea, in the early 20th century.
Why are the DJIA and DJTA used in Dow Theory?
The DJIA and DJTA are used because they are representative of the overall industrial production and transportation sectors, respectively. The theory posits that the health of these sectors reflects broader economic conditions and market trends.
Is Dow Theory still relevant today?
Yes, many traders and analysts still consider Dow Theory relevant. Although the specifics of the market have evolved, the concepts of trend confirmation and the importance of leading indicators remain valuable tools in technical analysis.
How does Dow Theory handle market corrections?
Dow Theory recognizes market corrections as a natural part of trend movements. Corrections are temporary reversals that should not be mistaken for trend reversals unless both DJIA and DJTA confirm the shift.
Related Terms
- Technical Analysis: A methodology for forecasting the direction of prices by studying past market data, primarily price and volume.
- Trend: The overall direction in which a market or the price of an asset is moving.
- Bull Market: A financial market where prices are rising or are expected to rise.
- Bear Market: A market condition where prices are falling or are expected to fall.
- Market Correction: A short-term price decline of typically 10% or more in a stock, bond, commodity, or index that is a part of the normal market cycles.
Online References
Suggested Books for Further Studies
- “The Dow Theory” by Robert Rhea: A classical book that provides in-depth insights and analysis of Dow Theory principles.
- “Technical Analysis of the Financial Markets” by John Murphy: A comprehensive guide to technical analysis, including a section on Dow Theory.
- “A Random Walk Down Wall Street” by Burton G. Malkiel: An exploration of various investment strategies, including a discussion about Dow Theory.
Fundamentals of Dow Theory: Technical Analysis Basics Quiz
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