Charles Henry Dow was born in the United States in 1851. Journalist, he got in touch with the world of finance through numerous interviews with entrepreneurs and finance professionals at the time.
At the age of 21, he started working as a reporter for the Springfield Daily Republican, where he learned to write quality texts. He was then editor at the Providence Star newspaper. In 1877, he joined the Providence Journal, where he began to report business stories and the development of industries and their future aspirations. After his success with the articles, he was assigned to work with bankers in Leadville, Colorado, reporting on silver mining. The bankers’ intention was to generate publicity to win investors in the mines. During this period, Charles Dow learned more about the Wall Street investment world. Then he entered the Kiernan Wall Street Financial News Bureau in New York with his friend Edward Davis Jones.
In 1882, he teamed up with Edward Jones to create his own company, Dow, Jones & Company. They wrote easy-to-understand newsletters with the day’s top financial news. Its publications were so successful that, in 1889, the company started publishing its own newspaper, the Wall Street Journal. The proposal was to offer material that would become a reference for consulting companies’ financial information. In 1898, The Wall Street Journal ceased to cover only the financial market and expanded the range of subjects.
With the end of the recession, Dow realized the need for investors on stock activity. It was then that, in 1896, he created the Dow Jones Industrial Average, and a year later, he created Dow’s Theory. Charles Dow died at 51 years of age in 1902, due to health complications.
Dow Jones Index
The index appeared in 1885 and consisted of 2 companies in the industrial sector and 12 other railway companies. In the following year, he defined the formation of the index using only 12 companies and named it Dow Jones Industrial Average (DJIA). Its value was made up of the average stock values of the 12 companies, and its objective was to portray the market movement. In 1929, the Dow Jones started to be formed by 30 companies and remains with that amount until the present day.
The shares that are part of the index are selected by a committee, composed of 2 editors of the Wall Street Journal and 3 people from the company S&P Dow Jones Indices. To integrate the index, the company chosen must:
- Be of North American origin;
- Represent your industry;
- Have an excellent reputation;
- Have a sustainable business model;
- Attract the interest of a large number of investors.
Dow’s theory is one of the main concepts used as a basis for technical analysis. It provides support for understanding and studying variations in asset graphs. In his theory, Charles Dow developed 6 basic foundations to serve as a basis for technical analysis.
Principle 1: indices discount everything
According to Dow, the indices discount everything, as they reflect, in a comprehensive way, the decisions of investors, including the most informed about events and trends. By constantly varying, the indexes discount everything that is predictable and what may affect the demand and supply of assets. Even chance events, such as the occurrence of unpredictable natural accidents, are quickly assessed and prices impacted due to their effects.
Principle 2: the market has three trends
Stock prices move in three trend categories. The primary (1), considered by Dow to be the most important, lasts more than a year and indicates the direction of the market. Secondary (2) is a medium-term movement trend, which generally lasts from one month to one year and develops both in the direction and correcting the main trend. Tertiary (3) normally lasts less than a month and corresponds to the short-term fluctuations of the secondary trend.
In the graph below, these three categories of trends are identified.
Principle 3: the primary upward trend has three phases
The initial phase of the primary upward trend is called accumulation (1). This phase is characterized by few buyers, considering the short time that has elapsed since the end of the last bearish phase of the market, when many investors suffered losses. The feelings of despondency and pessimism still prevail, deepened by the profusion of discouraging news. However, some investors well informed about facts or perspectives start to buy, accumulating positions with very low prices, hence the name given to this phase.
The next phase, known as the public participation (2), is characterized by the entry of investors, among them the technicians who, attentive to the accumulation of the best informed investors, start opening long positions. It is considered the longest phase of the primary upward trend, in which there is a significant increase in the number of investors and volumes traded. The last phase of the primary upward trend is called euforia (3). It is a period characterized by excessively high prices, resulting from the exponential growth in the number of investors and speculators present in the market. There is an atmosphere of great excitement and optimism, fueled by the confidence gained from the gains obtained in the previous highs.
The three phases of the primary upward trend are identified in the graph below.
Principle 4: the primary downward trend has three phases
The so-called distribution phase marks the beginning of the primary downward trend. It shows a decrease in traded volumes, which denotes the beginning of the exit movement of the best informed investors. The optimistic news still prevails, which makes the general public believe in the continuation of the upward trend and demand the shares “distributed” by those who are slowly realizing their profits. In the public participation phase, the number of investors closing their long positions increases, while many open short positions. The speed of profit making increases as the news becomes increasingly pessimistic. With the confirmation of the downward trend, big investors no longer worry about hiding their exit movement.
The third and final phase of the primary downward trend is called panic. Prices continue to fall, bringing total discredit to the market. Investors who were reluctant to divest their positions, believing in a supposed recovery, decide to realize their losses. As stock prices reflect this depletion, professional investors start pricing a reversal in expectations, opening new purchases and starting a new accumulation cycle.
Principle 5: volume should confirm the trend
The volume is defined, according to Dow’s theory, as the number of shares that were traded by all market participants during the trading session. The analysis of how the volume behaves in relation to the price movement is a way of verifying the commitment of investors in relation to the current trend. In a main upward trend, volume is expected to follow prices, that is, to increase when prices rise and decrease when prices fall. If there is a main downward trend, the relationship is reversed: the volume is expected to increase when prices devalue and to decrease when prices appreciate.
Principle 6: the trend needs to be confirmed by two indices
The confirmation principle states that a trend can only be considered valid when confirmed by different indices. In defending this principle, Dow aimed to provide investors with greater security in interpreting price movements. Nowadays, several parameters are used for confirmation, such as graphs of market indices, specific sectors or shares of different classes of the same company.