Understanding Dow Theory: Technical Analysis 101

BALTIMORE (Stockpickr) – Can a 100-year-old investment strategy still make money in today's markets? You bet!

"Dow Theory" is a term that's thrown around quite a bit, in classrooms as well as on trading floors -- but unlike many academic market studies, Dow Theory actually has real world trading implications. Here's a look at how Dow Theory works and why modern traders should be concerned with this century-old trading strategy.

While Charles Dow may be one of the most storied names on Wall Street, many investors don't fully realize the contributions that the Wall Street Journal founder made to modern-day technical analysis. Around the turn of the century, Dow was the foremost expert on broad market movements, creating the first market indices, the Dow Jones Transportation Average (then known as the "rails" index for its exposure to railroad stocks) and the ubiquitous Dow Jones Industrial Average.

Over the course of his career, Charles Dow wrote hundreds of editorials that discussed his take on market structure and price behavior as well as the relationships between his averages. After his death, those editorials were compiled by Dow's successors at the Journal (namely William Peter Hamilton and Robert Rhea) to create Dow Theory as it stands today.

While not developed as an explicit trading system by Dow, that's exactly what it became in the years after its creation.

Basic Tenants of Dow Theory

While considerable work has been done on Dow Theory, it can be divided into a handful of core tenets. First off, the market is broken down into three different movements of either direction: primary trends, which last for years and are inviolate; secondary or intermediate trends, which last for weeks or months; and minor trends, which last for days or less, and are irrelevant for Dow Theorists.


Those trends are significant because they dictate which direction investors should be betting on the market. Along the way, those trends should be confirmed by volume, and each has its own lifecycle of accumulation, public participation, and distribution.

These trends manifest themselves in the averages, or the broad market. As an investor, the ideal trade is to buy into a primary trend and hold as the market bears out its direction. Keys to doing that include ensuring that the averages confirm each other (that is, a bottom in the Dow Jones Industrials coincides with a bottom in the Transportation Average), and realizing that the averages discount all external factors that could affect the market.

In practice, following the system of Dow Theory means buying a diverse basket of stocks when the Dow Jones Industrial Average and Transportation Average confirm new highs and selling when the averages diverge or form lower lows.

First, though, applying the strategy requires a trader to identify the primary trend direction and the market's current state -- be it trending with the primary trend or correcting with an intermediate trend. The latter provides a lower-risk entry opportunity. Because determining the investibility of the market is based on two standard indexes, aligning your portfolio with this system just requires straightforward periodic analysis of the two averages.

Over the years, different analysts and traders have developed their own Dow Theory systems using different mechanical signals to trigger trades. The end results have been similar, though.

The Benefits of Using Dow Theory

In essence, Dow Theory is a technically driven money management strategy that helps investors stay invested when markets are looking strong, and signals an exit from stocks when the market is showing weakness. While academic support for Dow Theory had been mixed in past decades, new advances in statistical portfolio analysis have uncovered some telling results.

Most notable is the fact that on a risk-adjusted return basis, Dow Theory has historically vastly outperformed buy-and-hold investing. That's because the exit signals that Dow Theory provides yields significantly lower market exposure (and smaller drawdowns) for its followers. More recent backtests using a long/short strategy have delivered even more impressive results:

According to research from Martin Pring’s book Technical Analysis Explained, buying and holding a basket of Dow stocks between 1897 and 1990 would have turned an initial $44 investment into an admittedly impressive $2,500; using Dow Theory to manage that same $44 would have turned it into $51,268. Not surprisingly, today, a considerable number of investors have started using an offshoot of Dow Theory in managing their money.

While the in-depth specifics on Dow Theory are far too detailed to delve into here, hopefully we've whet your palate for more details on applying Dow Theory to your portfolio. While this investment strategy may be a century old, it’s still got the ear of a sizable chunk of Wall Street. 

This article is commentary by an independent contributor.

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