Stock Market Masters

Very rarely does a person come along whose name becomes synonymous with an industry. Charles Dow, however, was such a man. When he first established the Dow Jones Industrial average, I dare say this quiet man from Connecticut had no aspirations for his index to be referenced as “the stock market” 100 years later on the nightly news. But that is exactly what happened.

First published in 1896, the Dow Jones Industrial average is so closely aligned with the stock market and overall economic health that one may mistakenly assume Dow invented the market itself! Often news announcers and columnists alike will say, “The stock market moved 86 points today,” when in reality they are saying, “The Dow Jones Industrial Average moved 86 points today.”

It is more interesting still that relatively few people have a clue of Dow’s genuine contribution to the world of finance and specifically stock market analysis. So to honor Dow, I am going to write a series of 7 articles explaining what has become known as “Dow Theory” in this section of Stock Market Masters. This first article will focus on the life of Charles Dow, and each subsequent article will take a close look at each of the 6 primary tenants of his theory of stock market behavior.

Introduction to Charles Dow

Charles Dow was the son of a farmer, born on November 5th, 1851, in Sterling, Connecticut. Regarded by many as a quiet, honest man, what Dow lacked in formal education he made up for in pure tenacity and determination to discover the truth. His strong will and knack for investigation led him to become a journalist at the age of 21 and eventually led him into the field of financial journalism. By the age of 29, Charles Dow found himself in the big city of New York writing daily financial columns.

In 1889 Dow and his buddy Edward Jones started and published the first edition of the Wall Street Journal. By 1896 Dow had researched the most influential movers of the economy and devised an index to track the overall market. The first issue of the index was comprised of only 12 stocks, all stocks which were said to represent the industrial side of the country’s economic well being. Just a few short months later, Dow began to also publish a transportation index that initially consisted of 11 companies, 9 railroad and 2 non-railroad stocks. Even though these two indexes have grown to represent 50 companies (30 in the industrial average and 20 in the transportation average) and several companies have come and gone from the indexes, they are still in common use today and are considered by many to be extremely accurate gauges of the overall health of the economy.

While these two indexes bearing the name “Dow Jones” are certainly the most widely recognized claim to fame for Charles Dow, some would argue they are not his greatest achievement. It is fair to say Dow actually created one of the first technical indicators through the use of his index, a monumental contribution to the world of financial analysis in and of itself.

But at the same time, Dow published in the Wall Street Journal a series of articles that outlined and documented his observations on the market, particularly as it related to the indexes. These writings would later become known as “Dow Theory” and would earn him the title as “The Father of Technical Analysis” in most circles.

The Establishment of a Theory

Charles Dow himself never referred to his writings as “Dow Theory.” That title was attributed to his work by William Peter Hamilton (Dow’s successor at the Journal). Through continued research and compilation, Hamilton codified Dow’s work and rightly credited it as “Dow Theory” in his book The Stock Market Barometer in 1922.

Throughout most of the 20th century, Dow Theory was dismissed by many as irrelevant, mostly because of some incomplete studies performed by Alfred Cowles in 1937. However, in more recent years Dow’s principles surrounding how the market moves have been resurrected.

With the advent of modern tools, traders have begun turning to technical analysis as a preferred method of analyzing stocks to the more traditional methods of fundamental analysis. In the process, the theories of Charles Dow have been brought to new light and newer studies have proven them to be incredibly accurate and a great insight into market behavior (Kirkpatrick 74).

On the most basic level, Dow’s principles of market behavior can be summarized into six basic tenants. They are:

1. The price discounts everything.
2. The market has 3 trends.
3. Major trends have 3 phases.
4. The averages must confirm each other.
5. Volume must confirm the trend.
6. A trend is assumed to be in effect until it gives definite signals that it has reversed.

These tenants form the basis for Dow Theory and can give both the trader and the investor great insight into likely future moves of a stock. Over the next 6 articles we will expand upon each of these tenants and talk about how they can assist in understanding better the future price direction of a stock.

If you would like to learn how to apply Dow Theory to your own trading, please visit our website and sign up for a free class.

Jeremy Whaley is Co-Founder of Trade Smart University, where he teaches internet based stock market classes to every day investors. His training and trading style is focused on reading the technicals of the market and allow traders to pull substantial profits no matter which direction the market is moving. If you would like to learn more about how to profit during times of extreme market volatility visit Trade Smart University for your chance to take a free class.

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