Dow’s Market Psychology - Trends, Volume, and Market Cycles

Charles Henry Dow (1851-1902) was an American journalist, editor, and co-founder of Dow Jones & Company, as well as co-creator of The Wall Street Journal. He is widely recognized as the "father of technical analysis," having pioneered the systematic observation of market behavior through price movements and trends. Dow began formulating his ideas about market cycles and investor psychology at a time when stock markets were still in their infancy and largely unregulated. His insights, initially conveyed through editorials rather than formal treatises, laid the foundation for what later became known as Dow Theory. Although Dow did not codify his ideas into a definitive book, his work profoundly influenced subsequent generations of analysts, traders, and investors, providing a structured approach to understanding the interplay between market forces and human behavior.

The theory, authored by the American journalist and publisher Charles H. Dow, co-founder of Dow Jones & Company and "The Wall Street Journal," was never codified by him into a coherent work. He died in 1902, and his concepts were extracted and systematized by his successors and collaborators. Despite this, Charles Dow is widely recognized as the "father of technical analysis," as he was the first to announce a set of principles that made it possible to determine the market's direction and became the basis for chart analysis. More than 100 years later, these principles remain relevant and are a constant canon in investor education.

Dow Theory in Technical Analysis

Technical analysis is a field of financial market analysis that focuses on studying price movements, trading volume, and historical patterns to predict future market behavior. Unlike fundamental analysis, which evaluates the intrinsic value of assets based on economic, financial, and corporate data, technical analysis examines market psychology and the dynamics of supply and demand as expressed in price charts. Its foundational framework is Dow Theory, formulated at the turn of the 19th and 20th centuries, which remains a cornerstone of modern technical methodologies and indicators.

Dow Theory, articulated by Charles H. Dow, asserts that markets are governed by recurring psychological and cyclical patterns. These principles have influenced generations of technical analysts, forming the conceptual backbone for methods such as trend analysis, oscillators, and volume-based strategies.

The Six Philosophical Pillars of Dow Theory

Dow Theory is based on six fundamental principles that define a unique approach to market analysis.

1) Markets Discount Everything

The central premise of Dow Theory is that an asset's market price reflects all available information, including public and private news, economic and political data, and even random events like natural disasters. The theory assumes that all expectations, hopes, disappointments, and knowledge of all market participants are already priced into the asset. As a result, there is no need for in-depth analysis of a company's financials or macroeconomic data, because everything important is already contained within the price itself.

A practical example of this principle is the case of Apple. In 2007, after the announcement of plans to introduce the iPhone, the company's stock price began to rise dynamically. This increase reflected investors' expectations for future profits from the new product, even before it hit the shelves. As a result, the stock rose by over 60% by the launch date, and by the end of the year, the increase exceeded 100%. This price movement is proof that the market "discounted" this information, incorporating it into the stock price long before the new product's profits became a reality.

This principle forms the philosophical foundation that distinguishes technical analysis from fundamental analysis. According to this approach, price is the integrated sum of all factors - economic, psychological, and random - that influence the market. In this way, studying the price becomes equivalent to studying all the forces that affect it, which eliminates the need (and even the point) of in-depth fundamental analysis for making investment decisions. If the market reflects everything, then the only meaningful tool for predicting future movements is the analysis of the price itself and its patterns.

2) There Are Three Types of Market Trends

Dow Theory identifies and classifies market price movements into three main categories, comparing them to ocean tides and waves. Each of these trends has a different time scale and plays a distinct role:

Primary Trend: This is the dominant direction of the market, lasting from several months to several years. It represents the "tide" of the market and is the movement on which investors realize the greatest profits.

Secondary Trend (Corrective): This constitutes a correction within the primary trend and usually lasts from several weeks to a few months. The secondary trend, compared to "waves," often retraces 33% to 66% of the previous price move. According to Dow, corrections are healthy and necessary because they counteract excessive speculation and normalize the market situation.

Short-Term Trend (Tertiary): This is the shortest trend, lasting from a few days to a few weeks. It is often described as "ripples on the surface of the water" and is seen as unpredictable "market noise."

3) Primary Trends Have Three Phases

Dow Theory describes the cyclical nature of financial markets by distinguishing three phases in every primary trend, both bullish and bearish. These phases reflect the psychology and activity of different investor groups.

Bull Market (Uptrend) Phases:

Bear Market (Downtrend) Phases:

These phases are a mirror image of market psychology. In the case of a bull market, the market begins with accumulation at the bottom and ends in the distribution phase at the peak. In the case of a bear market, the process is reversed.

4) Indices Must Confirm Each Other

Dow originally formulated this principle based on the correlation between the Dow Jones Industrial Average (DJIA), which tracked the largest industrial companies, and the Dow Jones Transportation Average (DJTA), which included transportation companies, mainly railroads. He believed that a market trend could only be confirmed when both indices moved in the same direction. A lack of correlation would signal weakness or uncertainty in the economy. For example, if the DJIA were to rise but the DJTA did not follow, it could mean that the industry was producing, but the goods were not being transported, suggesting an impending economic downturn.

Today, while this principle is viewed as a historical legacy, its literal application is limited. The structure of the economy has changed - transportation is no longer the sole and dominant barometer of its condition. Nevertheless, the idea of trend confirmation by related sectors remains relevant. Instead of the DJIA and DJTA, modern analysts can observe the correlation between a technology index (e.g., NASDAQ) and a semiconductor index, which helps confirm the strength of a trend in innovative sectors of the economy.

5) Volume Must Confirm the Trend

Trading volume is a key indicator of a trend's strength and reliability. According to Dow Theory:

Low trading volume during a major price move can indicate a lack of genuine market conviction, which makes the move less reliable. A historical analysis of Polish companies shows the significance of this principle. Price increases for Bogdanka were quickly met with profit-taking on high volumes, which ended in a continuation of the declines. In contrast, the breakout on Amica's weekly chart in 2017 occurred on low volume, making the sell signal weaker than in the case of the dynamic decline in 2021, which was accompanied by high volume.

6) A Trend Remains in Effect Until There Is Confirmed Evidence of Its Reversal

According to this principle, once a trend is formed, it tends to persist until clear signals of its reversal appear. This is a key element for investors that teaches discipline and patience. In an uptrend, as long as each successive high and low is higher than the previous, the trend remains intact. A change to a downtrend is only certain when the market generates a lower high and a lower low.

This principle is a psychological antidote to the temptation of panic or FOMO (Fear of Missing Out). The market often experiences sharp movements that look like a trend change but are actually just corrections within a secondary trend. Investors, driven by fear or greed, often make hasty decisions by trying to predict the turning point. Dow's principle protects against this by instructing investors to wait for clear confirmation of a reversal. In other words, evidence of a trend change is more important than entering a position early.

The Evolution and Criticism of Dow Theory

Charles H. Dow never compiled his tenets into a single work. This mission was undertaken by his successors. William Peter Hamilton, who was the editor of "The Wall Street Journal" from 1908-1929, was the leading advocate of Dow Theory and largely formalized it. His 1922 book, The Stock Market Barometer, was the first extensive work that described and analyzed Dow's principles based on market movements since 1897.

Later, Robert Rhea, who studied Dow's work for 10 years during an illness, further systematized it. In his 1932 book, The Dow Theory: An Explanation of Its Development and an Attempt to Define Its Usefulness as an Aid in Speculation, he meticulously analyzed 252 of Dow and Hamilton's editorials, providing a practical guide for individual investors. Rhea believed that Dow's approach provided the only accurate method for forecasting stock market movements.

Historical Criticism and Challenges

Dow Theory has not been immune to criticism, both historical and modern. One of the most famous charges came from a 1934 study by Alfred Cowles. It was originally intended to show that Hamilton's strategies, based on Dow Theory, were not able to systematically beat the market between 1902 and 1929.

Later analyses, however, showed that Cowles's conclusions were flawed. Cowles compared the returns of a portfolio that was always fully invested in stocks with the returns of Hamilton's strategy, which was not always in the market. Hamilton's strategy assumed that an investor would be in long positions for 55% of the time, in short positions for 16%, and hold cash in safe securities for 29% of the time. Cowles did not account for the fact that a strategy based on Dow Theory was significantly less risky because it allowed for exiting the market during downturns. When Hamilton's returns were adjusted for risk, it turned out that his strategy actually generated positive, risk-adjusted returns, easily outperforming the passive strategy of full investment. This shows that Dow Theory, contrary to early accusations, has a historical basis in practice.

Modern Drawbacks and Limitations

Despite its timeless nature, Dow Theory has certain limitations that are particularly visible in the context of today's markets.

Dow Theory and Modern Market Analysis

Dow Theory, while a powerful set of principles on its own, gains strength when combined with other analytical tools. It serves as a "map" that helps the investor identify the market's main direction, while other indicators act as a "GPS" for more precise timing of entries and exits.

An excellent example is combining Dow Theory with popular oscillators like MACD (Moving Average Convergence Divergence) and RSI (Relative Strength Index). Dow Theory helps identify whether we are in a long-term uptrend, and RSI and MACD can signal that a secondary correction is in an overbought or oversold phase, which provides a signal to enter a position. This strategy allows for more precise timing of transactions without waiting for the "official" Dow trend change signal. It is a complementary approach that reduces the number of false signals and allows for more confident investment decisions.

Dow Theory vs. Other Methods

Dow Theory is often considered the foundation for many more advanced theories of technical analysis that have expanded and detailed its original principles.

The Challenge of Modern Markets: Cryptocurrencies and Algorithmic Trading

In the digital age, Dow Theory faces new challenges. In cryptocurrency markets, which do not have traditional industrial or transportation indices, the literal application of the index correlation principle is impossible. Nevertheless, the basic assumptions regarding psychological cycles, such as accumulation and distribution, are widely used by crypto traders who look for these patterns on Bitcoin or other asset charts.

The real challenge, however, is algorithmic trading (HFT). HFT uses advanced computer programs to execute a huge number of transactions in fractions of a second, aiming to exploit minimal price discrepancies. Dow Theory, based on slow, human psychology and long-term trends (months, years), is less effective in short-term trading dominated by algorithms. Algorithmic trading introduces a huge amount of "noise" into the market, which disrupts and masks the original interpretation of short-term trends, or "ripples on the water."

However, Dow's fundamental principles concerning long-term trends remain relevant. Although HFT generates significant volatility in the short term, the primary market cycles are still driven by larger economic forces and the collective decisions of investors, including institutions. Dow Theory can still serve as a barometer for these macroeconomic and psychological cycles, providing valuable context for long-term investors.

Summary and Recommendations

Dow Theory, while over 100 years old, is not outdated but rather timeless. It should be seen not as a ready-made strategy that guarantees success, but as a set of rules and guidelines. It serves as a philosophical guide to the market that teaches patience and thinking in terms of primary trends, not one-off, sharp movements.

Key Takeaways

Recommendations for the Investor

Dow Theory Principles at a Glance