Dow Theory: The Foundation and Philosophy of Technical Analysis

Dow Theory is widely regarded as the founder of technical market research. Although it is often criticized for "reaction lag" and may not be fully accepted by some people at a particular market stage, it is mostly known and respected by those who have been exposed to the market. Many people are not fully aware that the theory is purely technical in nature and is based on the behavior of the market itself (usually reflected by indices) rather than the business statistics on which fundamental analysis relies.

The formation of Dow Theory took decades of development. After the death of its founder, Charles Dow, William P. Hamilton and Robert Rea inherited and developed his ideas, systematized and organized them through subsequent discussions on the market, and finally formed the theoretical system we see today. Their "Stock Market Barometer" and "Dow Theory" have also become the classic documents of later studies in this field.

It should be noted that Charles Dow himself has said that the theory is not used to predict the trend of the stock market, or even to directly guide investment operations, but more like a "barometer" reflecting the overall trend of the market. Many people regard it as a mere technical analysis tool, which may miss its deeper value. In fact, the greatest contribution of Dow Theory is the valuable philosophical thought it contains, which is its essence. In all his works, Rea emphasizes that Dow Theory is essentially an auxiliary tool to help improve the understanding of traders or investors, rather than an absolute technical system that can be divorced from the basic conditions of the economy and the reality of the market. From its definition, it is a technical theory based on the study of price patterns to infer future price behavior.

In Mr. Rea's Dow Theory, he elaborates on three fundamental assumptions and five core "theorems" that are crucial to the theory and remain highly relevant in today's marketplace. Of course, we need to understand the implications in depth, not just take them literally.

The three basic assumptions of Dow Theory are similar to those of common technical analysis theories, but Dow Theory focuses more on the interpretation of the inherent meaning of the market.

Assumption 1: The daily and weekly fluctuations of market indices or individual securities may be influenced by short-term human factors, and the secondary reversal trend may also be disturbed to some extent, but the main trend of the market will not be influenced by human manipulation.

Some people may think that large funds can manipulate the main trend of securities. In the short term, even if there is no active manipulation, securities that are capable of manipulation can be influenced by other forces; from a long-term perspective, the evolution of company fundamentals will continue to create new market conditions. Overall, the main trend of a company's stock price is still fundamentally difficult to be continuously artificially manipulated, and it may only change the investors involved and the specific market environment.

Assumption 2: Market indices digest all information. The expectations, concerns and knowledge of every market participant who is knowledgeable about financial matters are ultimately reflected in the daily closing fluctuations of the relevant market index. Therefore, market indices always properly predict the possible impact of future events.

Markets are complex and elusive in the eyes of most people, with participants constantly making assessments and judgments and incorporating their own psychological factors into the decision-making process.

Hypothesis 3: Dow Theory is an objective analytical theory. Successfully applying it to assist trading decisions requires in-depth research and objective judgment. Once too much subjective judgment is added, it is easy to lead to decision mistakes.

Five core "theorems":

Theorem 1: Three trends in the market (short-term, medium-term, and long-term trends)

There are three trends in the market at the same time: the short-term trend, which lasts for days to weeks; the medium-term trend, which lasts for weeks to months; and the long-term trend, which lasts for months or even years. These three trends are bound to coexist, but they may go in opposite directions.

Long-term trends are the most critical and easiest to identify and understand. They are what investors need to pay attention to. Medium- and short-term trends are nested within long-term trends, and they can only be better understood and exploited if their position relative to long-term trends is clear.

The medium-term trend is relatively minor for investors, but it is the main consideration for traders. It may be in the same direction as the long-term trend, or it may be in the opposite direction. When the medium-term trend deviates significantly from the long-term trend, it is considered a secondary reversal or correction. The secondary reversal trend needs to be carefully evaluated to avoid misjudging it as a fundamental shift in the long-term trend.

Short-term trends are the most volatile and difficult to predict, and are usually the focus of short-term traders. Investors and swing traders only care about short-term trends in a few situations, such as finding more favorable buying and selling opportunities to optimize returns or control risk.

Dividing price movements into three trends is not a theoretical game. Investors who understand these three trends, even if they focus on long-term trends, can use contrarian medium- or short-term fluctuations to enhance returns. There are various ways to do this, such as operating in the secondary correction stage of a long-term uptrend, or using short-term fluctuations to find better buying and selling points under the premise of clear trend context.

These ideas are also valuable for traders, although traders usually do not take positions against the main trend in secondary pullbacks. Their goal is to move in the direction of the medium-term trend. Traders can catch signs of a possible shift in the medium-term trend by observing changes in the short-term trend. Although investors and traders have different mindsets, the basic principles for recognizing trend changes are similar.

With the development of information technology and the evolution of trading methods, the volatility of market medium-term trends has increased in recent decades. Therefore, a pure "buy and hold" strategy may need to be adjusted according to market conditions. Focusing on medium-term trends may provide market participants with a more flexible and informed decision-making framework. Of course, to accurately grasp medium-term trends, it is necessary to deeply understand their interaction with long-term major trends.

Theorem 2: Main trend (long or short market)

Major movements represent the fundamental direction of the market as a whole, often referred to as long or short markets, and can last less than a year or as long as several years. Getting the direction of a major movement right is a key element in whether a trade can succeed. There is no exact way to predict the exact duration of a major movement.

Understanding major long-term trends is the cornerstone of successful trading or investing. Traders who have a clear understanding of long-term trends, complemented by the right timing, have the opportunity to earn good returns. Although it is impossible to predict the magnitude and length of major trends with precision, it is possible to use statistical methods to study the general laws of major trends and secondary reversals with the help of historical price data.

Interestingly, some of the core characteristics of market volatility are fairly stable based on historical statistics. This suggests that, despite advances in technology and knowledge, the psychological factors driving market price movements have not changed much in nature. This has important implications for professional traders: the magnitude and cycle of current market movements are likely to fall within the usual range of historical statistics. Recognizing this can help to assess market conditions and latent risks more rationally.

Theorem 3: Major bear markets (with three stages)

The main bear market is a long-term downward trend, interspersed with important rallies. It usually results from a series of economic corrections, and this trend will only gradually end when the stock price has fully reflected the worst possible expectation.

The development of the bear market tends to go through three main stages: in the first stage, market participants no longer believe that the overvaluation can be maintained; in the second stage, the selling pressure reflects the cyclical decline in economic conditions and corporate profits; in the third stage, investors may be disappointed with various assets, resulting in some positions seeking to liquidate regardless of value. It is worth noting that "important rebounds" are one of the typical characteristics of the bear market.

At the end of a short market, the market tends to become desensitized to additional negative news and pessimism. After a deep correction, the stock price may temporarily lose the momentum of a strong rebound, the market trading tends to be flat, and the buying and selling power reaches a relatively balanced state.