SIX BASIC TENETS OF DOW THEORY
1. The Average Discounts Everything
One of the basic premises of technical analysis is the idea that the market reflects every possible factors, and information that can possibly affect overall supply and demand.
While market can not forecast natural occurances such as: earthquake, storm, hurricane, and various other catastrophies, they quickly discount such events and almost immediately equate their affects into the price action.
2. The Market has Three Trends
According to Dow the market has three trends: uptrend, downtrend, and sideways trend.
An uptrend is defined as a situation in which each successive rally closes higher than the previos rally high, and each successive rally low also closes higher than the previous rally low.
In a downtrend the reverse is true. That is to say, each successive lower peaks closes lower than the previous low.
In sideways trend, each successive peak and crest are about the same height.
3. Major Trends Have Three Phases
According to the Dow Theory primary or major trends has three distinct phases:
- accumulation,
- public
participation
- distribution.
According to the Dow theory both the industrial and rail averages must move along the same direction to confirm either a bull or a bear market.
Dow considered a rally in the industrial averages should be accompanied by a rally in the railway averages too, thus confirming the bull market. According to this logic, industrial rally suggests manufacturing profits are up then it means consumer spending is up. This creates a chain of demand for goods so manufacturer's are producing more goods to fullfill the needs. In order to supply the goods, the manufacturer's must transport, in this case use railways as the mode of transporting goods to consumers.
When these two indicies: industrial and the railroads index move in tandem then only one could confirm that a major trend is in place.
5. Volume Must Confirm The TrendThe Dow theory states volume should increase along with price in the direction of the major trend. Dow considered volume as a secondary yet important factor in identifying price signals.
6. A Trend In Motion Will Likely Remain In Motion Until It Signals That It Has Definitely Reversed
This tenets of the Dow theory relates a physical law to market movement. It is also considered the foundation of many trend following indicators.
