Dow Theory is a study that establishes the connection between two stock indexes; the Dow Jones Transportation Average (DJTA) and the Dow Jones Industrial Average (DJIA). If one of them rises to an intermediate high, the other should follow within a short time; else, the two indexes are divergent and the market is ready for a reverse course.
Dow Theory originated from the publications of Charles Dow, the founder of the Wall Street Journal. In 1902, Charles Dow died and William Hamilton proceeded with Dow’s work and his personal findings till 1929. Robert Rhea combined the work of these two men and used it to release The Dow Theory in 1932.
The book explains the principles of technical analysis, such as describing the features of the primary, secondary, and minor trends. It further explains Dow Theory divergence.
The two indexes were the Rails and the Industrials in Dow’s time. The Industrial companies produced the goods, and the Rails were responsible for shipping them. By the time one index had a new intermediate or secondary high, the other index was expected to follow suit to validate the signal.
When the two indexes were in agreement and reached new highs or lows around the same time, the price action of each of them would be considered confirming.
Meanwhile, if the indexes were divergent, that one average went to a new high and the other maintained its position, then there was bearish divergence. If one index reached a new low and the other held above a previous bottom, then the divergence was bullish.
At present, the Rails are the Transports. The theory is argued to be valid; in that, the activities of the Industrials and Transports provide a filter to determine if the stock market is healthy or not.
Robert Rhea outlined certain assumptions that one must accept before following Dow Theory, and they are:
1. The primary trend cannot be manipulated. It is stated that in a widely liquid market like a country’s currency or major stock index, it is not possible to manipulate the statistics for a long period of time.
2. Markets discount everything. The meaning of this is that the price the market is trading at represents all information available concerning the state of the economy, interest rate, current pricing, etc.
3. The theory is not perfect; in that, it does not show how to outperform the indexes.
If you examine Dow Theory critically, you can discover where some other stock market strategies originated from.