The Dow theory is a trading approach developed by Charles H. Dow for technical analysis.
Charles H. Dow believed that the stock market is a reliable measure of overall business conditions within the economy. By analysing the overall market, one could accurately understand favourable and unfavourable conditions and identify significant market trends and the likely direction of individual stocks.
As per Charles Dow, there are three categories of market movement, also known as market trends. The first and most important is the primary trend which is significantly longer in time duration. The second and most distorted is the secondary trend which is shorter in nature than the primary trend. The third, and usually based on Intraday traders, is the daily movement, also known as market noise which lasts for a day to a week.
The Primary Trend
This is the market’s major trend that lasts from a year to several years. It indicates the broader direction of the market. In the world of investing, we also call primary trends a bull market or a bear market, depending on the movement. The primary trend can go either way. If the Primary trend goes down, then we say it’s a bearish trend, and if it goes upward, we call it a bullish trend. Only long-term investors or swing traders are interested in this trend. The primary trend also shows the performance of the large business listed on the stock exchange and can be called a barometer of the whole economy.
The Secondary Trend
When certain investors and traders start booking profits in the primary uptrend, we face a short-term reverse movement, which is popularly called a correction in the market. This correction in the market is nothing but a secondary trend. Think of this as a minor counter-reaction to the larger movement in the market.
For example – corrections in the bull market mean investors and traders are booking their profits, and corrections in the bear market mean certain investors and traders are accumulating and creating recoveries in the bear market. The secondary trend can last anywhere between a few weeks to several months.
The Minor Trends/Daily Fluctuations
Minor trends are day-to-day fluctuations in the market. Minor trends are short-term speculative movements that are totally irrelevant and often ignored. Most of the time, they are news-related and can be considered noise.
Why do we have minor trends? The answer is straightforward! Since the stock market offers a platform to trade in a security every day, then in the search for quick money, most intraday traders trade every day.
Assumptions in Dow Theory
The first assumption is that manipulating the primary trend is not possible. When large amounts of money from different parts of the world are at stake, the temptation to manipulate is bound to be present. Dow did not argue against the possibility that speculators, specialists, or anyone else involved in the markets could manipulate the prices. He qualified his assumption by asserting that it was not possible to manipulate the primary trend. Intraday, day-to-day, and possibly even secondary movements could be prone to manipulation. From a few hours to a few weeks, these short movements could be subject to manipulation by large institutions, speculators, breaking news, or rumours. Still, the primary trend is impossible to manipulate.
This is why long-term value investors depend on the primary trend, as they know that the primary trend reflects the genuine performances of the companies behind the trend.
The second assumption is that the market reflects all available information. Everything there is to know is already reflected in the markets through the price. Prices represent the sum of all the hopes, fears, and expectations of all participants. Interest rate movements, earnings expectations, revenue projections, presidential elections, product initiatives, and all else are already priced into the market. The unexpected will occur, but usually, this will only affect the short-term trend. The primary trend will remain unaffected.
The Dow theory operates on the efficient markets hypothesis (EMH), which states that asset prices incorporate all available information. In other words, this approach is the antithesis of behavioural economics.
Earnings potential, competitive advantage, management competence—all of these factors and more are priced into the market, even if not every individual knows all or any of these details. In more strict readings of this theory, even future events are discounted in the form of risk.
The third assumption is that all indices must confirm with each other. We cannot confirm a trend based on just one index. For example, the market is bullish only if CNX Nifty, CNX Nifty Midcap, CNX Nifty Smallcap, etc., all move in the same upward direction. It would not be possible to classify markets as bullish just by the action of CNX Nifty alone. All the large, medium and small capitalised stock indices must move in the same direction.
The fourth assumption is that the volumes must confirm along with the price. The trend should be supported by volume. The volume must increase as the price rises and reduce as the price falls in an uptrend. In a downtrend, the volume must increase when the price drops and decrease when the price rises. An increase or decrease in volume indicates the genuineness of optimism or pessimism in the market.
If there is an increase or decrease in prices with very low volume, then it is clear that a particular group of investors is manipulating the price.
It should be noted that in the world of finance and investment, volumes mean the number of shares traded during the day.
Brief History of Charles H. Dow as per Wikipedia:
Charles Henry Dow was an American journalist born in Sterling, Connecticut, on November 6, 1851. He co-founded Dow Jones & Company and The Wall Street Journal, which has become one of the most respected financial publications in the world. He also invented the Dow Jones Industrial Average as part of his research into market movements. He developed a series of principles for understanding and analysing market behaviour which later became known as the Dow theory, the groundwork for technical analysis.