Background
The idea of Charles Dow, the first edition of the Wall Street journal, are known as Dow Jones Theory. In 1900 Dow Jones wrote a series of articles emphasizing that the direction of Share market appeared to based on a set of rules. Collectively, these articles and rules become known as ' The Dow Theory '.
Dow expressed that the general level and trend of the stock market can be understood with the help of Index numbers/average constructed on the basis of price movements of some important stocks. He believed that the behaviour of Index numbers/averages reflects the hope and fear of the entire market. He created two averages to understand the price behaviour of the stocks in the USA.
(a) Dow Jones Industrial average :- It is an average price of 30 Blue chip US stocks prevailing in the New York stock exchange.
(b) Dow Jones Transport Average :- The Dow Jones Transportation Average is the most widely recognised indicator/average of the transportation sector of USA.
Dow Jones Theory
(1) A share price reflects everything that is known about a stock. This means that all the positive and negative about a company are assumed to be known by the market and built into the share price.
(2) Share market has three well defined movements which fit into each other :-
(i) Ripple :- It is the daily variation due to difference between buying and selling at that particular time or changes in very short period. Very short period is known as market period in economics. Such changes are due to instant reactions.
(ii) Wave :- It refers to the movements which cover a period ranging from day's to week's ( change in short period ). Such changes are generally referred to as corrections. Such changes do not reflect changes in fundamentals.
(iii) Tide :- It refers to the movement which is a great swing covering from months to the years ( Long-term, is also termed as primary trends ). Such changes are the results of the changes in fundamentals.
(3) Primary Trends :- Bull markets are broad upward movements of the market that may last for several years, interrupted by secondary reactions. Bear markets are long declines interrupted by secondary rallies. These movements are referred to as the primary trends.
Bull markets.
Bull markets commences with reviving confidence as business conditions improve.
Prices rise as the market responds to improved earnings.
Rampant speculation dominates the market and price advance are based on hopes and expectations rather than actual results
Dow defined a Bull trend as a time when successive rallies in a security price close at levels higher than those achieved in previous rallies and when lows occur at levels higher than previous lows.
Bear Markets
Bear markets start with abandonment of the hopes and expectations that sustain inflated prices.
Price decline in response to disappointing earnings.
Distress selling follows as speculators attempt to close out there positions and securities are sold without regard to their true value.
Bear trend occurs when markets make lower lows and lower highs.
(4) Trends are confirmed by volume :- Dow believed that the volume confirmed price trends. When prices move on low volume, there can be many different explanations. An aggressive seller could be present. But when price movements are accompanied by high volume, Dow believed this represented the true market view.
(5) Trends should be judged with the help of Share price Index numbers.
The purpose of Dow Theory is to determine the market's primary trend. Successful investing, according to the Dow Theory, means staying on the right side of the primary trend and ignoring short term movements. According to Dow, the primary trends can not be manipulated.
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