Understanding Dow Theory
- If a banking stock is rising, the Bank Nifty index should also reflect strength.
- If the broader market (such as Nifty 50) is in a bull trend, individual stocks should ideally support that movement.
- It is considered a lagging indicator, because by the time a trend is confirmed, the move may have already begun.
- It was built on older indices like the Dow Jones Industrial Average and Dow Jones Transportation Average, which may not fully reflect modern market structures.
- Critics argue that markets today move faster and may not follow traditional patterns.
- The market discounts everything.
- Trends exist in three forms: primary, secondary and minor.
- Accumulation, public participation and excess phases define long-term behaviour.
- Confirmation from broader indices or related sectors strengthens trend reliability.
- Despite criticism, trend-following remains the backbone of technical analysis.
Transcript
CA Manish Singh:
Hello everyone, and welcome to Chapter 9. In this chapter, we will learn about Charles Dow, the foundations of Dow Theory, why it remains relevant to market analysis even today, and how trends form, evolve, and confirm themselves in the stock market.
Dow Theory is the base on which most modern technical analysis has been built. Once you understand the principles, you will find it easier to judge market direction, phases, and investor behaviour.
What This Chapter Covers: Foundations of Dow Theory
CA Manish Singh:
Before understanding Dow Theory, we need to understand the person behind it. Charles Dow was the founder of a company called Dow Jones & Company, known globally for publishing The Wall Street Journal, one of the most respected financial newspapers in the world.
In the early days, Dow would write editorials about how he viewed the market. These writings gradually formed the core principles that later came to be known as Dow Theory.
These principles are the backbone of how we interpret trends, sentiment, and market behaviour in technical analysis today.
Let us now break the theory down step by step.
1. Dow Theory Principle: The Market Discounts Everything
CA Manish Singh:
The most important idea in Dow Theory is that the market discounts everything.
This means any information that can affect price, whether positive or negative, is already reflected in the market.
If a company is expected to grow or report strong numbers next quarter, the market begins pricing it in well in advance.
If an economy is expected to slow down, the market adjusts even before the slowdown shows in data.
This is why price action is considered the most honest indicator of what the market knows or expects.
2. Markets Move in Trends
CA Manish Singh:
Dow Theory says that markets move in trends, and each trend has three clear components:
a. Primary Trend (Long-Term Trend)
This is the major direction of the market.
For example, India has been in a long-term bull market because the country continues to grow and develop. This primary trend reflects the broader economic movement of the nation.
b. Secondary Trend (Medium-Term Trend)
These are corrective phases that occur within the primary trend.
For example, during COVID-19 or periods of global financial stress, the market corrected sharply. These corrections last weeks or months but do not change the primary direction.
c. Minor Trend (Short-Term Trend)
These are short-lived movements caused by events such as poor quarterly results from a company or short-term sentiment shifts. Minor trends may reverse quickly and do not define the long-term direction of an index or a stock.
3. Why Trends Form: Behaviour, News and Expectations
CA Manish Singh:
Every trend forms because of how people react to news, expectations and economic factors.
Example:
If the government cuts taxes, people have more disposable income.
More income means more spending.
More spending means stronger economic activity.
A stronger economy often leads to a stronger market.
Investors who recognise this early start accumulating.
This is called the accumulation phase.
When the trend becomes obvious, the public enters.
This is the public participation phase.
Finally, when the excitement becomes excessive and everyone wants to buy, early investors start exiting.
This is called the excess phase and often marks the beginning of the next correction.
Understanding these phases helps you read long-term behaviour.
4. Confirmation in Dow Theory
CA Manish Singh:
A trend is considered confirmed only when other related indicators or indices show the same direction.
For example:
If a banking stock is rising, the Bank Nifty index should also reflect strength.
If the broader market (such as Nifty 50) is in a bull trend, individual stocks should ideally support that movement.
This alignment strengthens the validity of the trend.
5. Criticism of Dow Theory
CA Manish Singh:
No great idea is without criticism, and Dow Theory is no exception.
Some of the common criticisms include:
It is considered a lagging indicator, because by the time a trend is confirmed, the move may have already begun.
It was built on older indices like the Dow Jones Industrial Average and Dow Jones Transportation Average, which may not fully reflect modern market structures.
Critics argue that markets today move faster and may not follow traditional patterns.
However, despite these criticisms, the foundation of Dow Theory remains strong.
A trend is a trend until the market clearly shows otherwise.
6. Why Dow Theory Still Matters
CA Manish Singh:
Technical analysis is nothing but the study of trends.
If a stock is in a bearish trend, there may be temporary bounces, but the overall trend remains down until proven otherwise.
If a stock is in a long-term bull trend, short-term dips do not change the broader direction.
Dow Theory teaches discipline, clarity and respect for trend behaviour.
These qualities help traders avoid emotional decisions and stick to structured rules.
Summary and Takeaways
The market discounts everything.
Trends exist in three forms: primary, secondary and minor.
Accumulation, public participation and excess phases define long-term behaviour.
Confirmation from broader indices or related sectors strengthens trend reliability.
Despite criticism, trend-following remains the backbone of technical analysis.
In the next chapter, we will learn about moving averages and understand how they help identify and follow trends more effectively.
Disclaimer:
Investments in securities markets are subject to market risks. Read all related documents carefully before investing.