Dow Theory Decoding Unveiling the Principles of Technical Analysis

The Dow Theory has always been an important part of technical analysis, used extensively even before the adoption of western candlestick charting. Even today, traders combine the two to create optimal practices for stock trading.

Charles H. Dow, the founder of the Wall Street Journal and creator of the Dow Theory, was celebrated for a series of articles that he published beginning in 1900. William P Hamilton then spent 27 years compiling them with relevant examples, paving the way for modern interpretations. While many acknowledge Charles Dow’s contributions, there still remain critics and supporters of his theories today.

The Dow Theory Principles

The Dow Theory is constructed on a few ideas, which Charles H Dow developed through the course of his examination of the markets. There are nine guiding principles associated with this theory, as follows

The different phases of Market

According to the Dow Theory, markets go through a cyclic pattern of three different phases which recur. The Accumulation phase is the first of these, followed by the Markup period and finally, the Distribution stage.

The market sell-off typically follows a deep dip in stock prices, leaving many participants feeling dejected and pessimistic about a potential increase. Fearful of another plunge, buyers remain cautious, and prices stay low. This is when ‘Smart Money enters the market- dubbing it ‘Accumulation phase.’

Smart money is usually institutional investors who take a long-term view – seeking value investments during steep sell-off periods. Accumulation phases occur when these investors buy large volumes of shares over an extended period. This creates a market for sellers to offload stock without causing prices to plunge further, consequently forming support levels. This phase can last for several months. 

When smart money investors absorb the available stocks, this typically leads to a surge in sentiment for the business. This phenomenon is named the Markup phase, characterized by a rapid rally of stock prices. The unique aspect here is its speed, leaving most public investors with missed opportunities. Investors are stunned at the returns, and everyone, including the public and analysts, sees a higher level ahead.

When stock prices hit levels of either 52 week high or an all-time high, there is a sudden buzz in the market as news reports take an optimistic turn and the public shows enthusiasm towards investing. This environment inevitably leads to the distribution phase.

Smart investors who got in early will gradually begin selling their shares. These sales volumes will be taken up by the public, which will help to create price support. The distribution phase is similar to the accumulation phase in terms of pricing. 

Whenever prices try to go up during the distribution phase, smart money investors step in and sell off their holdings. This repeatedly occurs over time, thus forming a resistance level.

Once institutional investors (smart money) have sold off their holdings, there will be no more support for prices. Consequently, the markets experience a sizable markdown in prices, often called a sell-off. This can leave the public feeling utterly frustrated.

The cycle from accumulation to selloff is thought to span a few years, with a fresh round of the former occurring after the latter. The entire process then repeats itself.

It is essential to take note that every market cycle is unique. For instance, the Indian bull markets of 2006-07 and 2013-14 stand in stark contrast to each other. The transition from accumulation to distribution may take place either over a long period or happen swiftly in a matter of months. It is hence imperative for market participants to accustom themselves to assessing markets within different phases, to form an outlook on the market.