Dow Theory

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Chapter 24 — Dow Theory
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Dow Theory

The first widely used technical analysis theory was the Dow Theory, developed by Charles Dow in 1900 (the same man who founded The Dow Jones). First, it says that the share price reflects everything that is currently known about a stock, and there is no such thing as an undervalued stock (today this is known as the efficient market hypothesis). However, stock prices also have three trends influencing the direction of the stock’s price:

 

The first trend is the primary macro trend lasting more than one year, which starts as aggressive buying by well-informed investors anticipating a market recovery. This moves on to general buying by average investors as economic conditions improve, and then becomes a rush into stocks by everyone else as the well informed investors begin to sell out. The secondary trend is a “market correction” away from the primary trend that lasts for one to three months. And the tertiary or minor trend is a small short-term movement lasting between one day and three weeks.

 

To confirm a trend, check the volume. Market rallies often happen while there is increasing volume, and market declines often come with decreasing value. Once a trend is confirmed, follow it until there is a definite sign of a reversal. The longer a primary trend has been in play, the more likely that the trend will be broken soon.

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