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A reporter and journalist, Charles Dow wrote editorials that were published in The Wall Street Journal in which he presented his theories on predictive analysis of the stock market. Dow never formally organized his theories into a cogent whole, and never wrote a book on his findings.

The term “Dow Theory” was coined by author A.C. Nelson, who organized Dow's Wall Street Journal editorials into a book called The ABC of Stock Speculation around the time of Dow's death in 1902.

William Peter Hamilton, who became publisher of the Journal after Dow's passing, based his 1922 book The Stock Market Barometer on Dow's tenets. In 1932, Robert Rhea further refined these concepts in his work, titled The Dow Theory: An Explanation of Its Development and an Attempt to Define Its Usefulness as an Aid to Speculation.

Here are the basic concepts of Dow Theory:

The Averages Discount Everything. All that is known or knowable about a stock is reflected in its price. Information is acted upon, and these actions are reflected in the price of the individual stocks, and by extension, the stock averages. If an event is widely anticipated, its occurrence is likely already reflected in the indices before it happens.

Therefore, the markets don't necessarily reflect current circumstances; they often reflect anticipated future circumstances. This is why you'll sometimes see a stock market that seems completely disconnected from the current economy; at such times, the market isn't concerned with the state of the economy as it is today, but with its future condition. The notion of the price as a predictive mechanism, rather than a reflection of past or current events, is one of the lasting innovations of Dow's work.

The Market Has Three Trends – Primary, Secondary, and Minor. In today's trading vernacular, perhaps a more concise way to express this would be “the market has three time frames.”

The primary trend is measured in years. The terms “bull market” and “bear market” apply to the primary trend. A secondary trend is a counter-trend, corrective movement within the primary trend that normally lasts from three weeks to three months. A minor trend refers to short-term movement within the secondary trend, and normally lasts for less than three weeks.

According to Dow Theory, the primary trend is of the greatest concern and presents the greatest opportunities. The secondary trend also creates trading opportunities, while the minor trend is usually of little consequence. The concept of trading across multiple time frames stems from this part of Dow's work.

What is a trend? As mentioned in previous chapters, an uptrend consists of a series of higher highs and higher lows, while a downtrend consists of a series of lower highs and lower lows.

Trends Are Persistent

Another tenet of Dow Theory that has stood the test of time is the concept of persistent trends. When the primary trend is in effect, a Dow Theory practitioner assumes that the trend will continue. This assumption stays in effect until clear reversal signals appear, such as the transportation and industrial averages together forming a series of lower lows.

Because of the persistence of trends, traders should focus on trading in the same direction as the primary trend. They should avoid trading against it, with the possible exception of short-term trades.

A trend has three phases – accumulation, public participation, and distribution.

“Accumulation” refers to buying by those “in the know.” Often, this occurs after a market suffers sharp losses, and at a time when the general public has no desire to participate.

After a market has been rising for some time, the public participation phase begins. This occurs as the general population recognizes the existence of a bull market and decides to begin buying.

“Distribution” begins to occur as the bull market matures; this phase is often marked by wildly bullish sentiment, widespread public interest in the markets, and conspicuous representations of the bull market (on magazine covers, on television, and in movies).

Confirmation

“Confirmation” is another lasting tenet of Dow's work. In reference to Dow Theory, confirmation specifically refers to the relationship between the Dow Jones Industrial Average and the Dow Jones Transportation Average.

In order to confirm a bull rally, both indices must exceed a previous major high point. An excellent example of this would be if both the transports and the industrials were to reach an all-time high on the same day.

A bear move is confirmed when both indices make new lows beneath a previous major low point. If either index fails to confirm the other, the move is considered suspect.

Figure 4.1 is a comparison chart that demonstrates confirmation: The Dow Jones Industrial Average (black line) reached a new all-time closing high of 17810.06 on November 21, 2014 (point A). On the same day, the Dow Jones Transportation Average (gray line) also reached a fresh all-time closing high at 9094.16.

Figure 4.1 The Dow Jones Industrial Average (black) and the Dow Jones Transportation Average Reach Simultaneous New Highs, Resulting in a Dow Theory Buy Signal

This confirmation creates a Dow Theory buy signal. The simultaneous new highs are considered particularly bullish. Both indices made subsequent new highs, resulting in another buy signal in December of 2014.

The length of time that passes prior to a confirmation signal is also taken into consideration. When confirmation occurs quickly, as it does in Figure 4.1, the signal is considered strong. However, if there is a considerable lag time before the confirmation occurs, the signal is considered less potent.

When confirmation fails to occur, it is not considered a buy or sell signal, but it can be considered a warning sign. In Figure 4.2, we see another comparison chart of the Dow Jones Industrial Average (black line) and the Dow Jones Transportation Average (gray line). Notice how the two indices are trading in tandem on the left side of the chart, and then diverge on the right.

Figure 4.2 A Divergence Between the Dow Jones Industrial (black) and Transportation (gray) Averages

On May 19, 2015, the Dow Jones Industrial Average closed at an all-time high of 18312.39 (point A). However, the Dow Jones Transportation Average failed to confirm this new high; in fact, the transportation index reached a six-month low just a few days later on May 22 (point B). This failure to confirm served as a warning to traders, who should have been bullish at the time, based on prior Dow Theory buy signals.

The divergence of these two indices tells us that the market wasn't as strong as it appeared to be on the surface. Weakness in the transportation index could be a sign that demand for products could be waning. However, this would not be assumed unless and until it is confirmed by price action in the industrial index.

While the divergence between the industrials and the transports in Figure 4.2 can be described as a warning sign, it's important to understand that it is not a sell signal. Divergence itself does not create a buy or sell signal as it pertains to Dow Theory.

Divergence can be used as a buy or sell signal outside of the realm of Dow Theory. For example, many traders use divergence between the MACD (moving average convergence/divergence) indicator and the price as a buy/sell indicator. However this type of divergence is unrelated to Dow Theory. We'll discuss MACD divergence in a later chapter.

When it comes to Dow Theory, there are no provisions for a neutral signal – it is always set to either buy or sell, based on the most recent signal. The most recent signal prior to the divergence in Figure 4.2 was a buy signal in December of 2014, so adherents of Dow Theory would have remained cautiously bullish.

In order to generate a Dow Theory sell signal, the Dow Jones Industrial Average would have to confirm the breakdown in the Dow Jones Transportation Average by breaking below a major low point. Both of the indices would have to break down in order to generate a sell signal, according to the theory.

Volume Confirmation

According to Dow Theory, volume is also used to confirm the trend. Ideally, a bull market should feature an increase in volume as prices rise, and turnover should decrease as prices fall. The opposite would be true for a bear market; volume should increase on days when the market is falling, and decrease as prices are rising.