The Dow theory was developed in the late 1890s by Charles Dow, one of the founders of the Wall Street Journal. The theory is based on the Dow Jones Industrial Average. There are five basic foundations of the Dow theory. First, the Dow theory looks only at the Dow Jones Industrial Average and Dow Jones Transportation Average. Second, the averages discount everything. Third, it looks at three movements in the market: the market’s primary trend; the secondary price movement; and the daily price movement. Fourth, the movement on both averages must be looked at together; confirming one without the other presents false results. And fifth, a primary trend stays intact until a change in the trend has been signaled by the theory.

Purpose and Strength of the Dow Theory

The purpose of the Dow theory is to determine the market’s primary trend. It is based on the idea that success on the stock market comes by watching the overall trend, rather than the short-term and secondary trends that happen within the market. The reason that the Dow has lasted as long as it has is due to its ability to avoid following the market’s every trend. The Dow paces itself, looking at what is happening in the long term, often for periods lasting a year. Those who follow the Dow theory are careful investors, willing to let their money multiply over the period of a bull market, rather than sell at any slight slip in the market.

Limitations of the Dow Theory

While the Dow follows long-term trends, it does not predict how high or how low the prices will go during the trend. Also, the Dow is often just slightly off the mark. Because it is looking at how things go over a long period of time, the market will have passed its high or low points by the time the Dow signals a shift in the type of market attitude. That means followers are unable to take advantage of the market’s optimum buying or selling prices.

However, over the past fifty years, the Dow has proven itself to be one of the most accurate predictors of market trends.