Charles Dow was the creator of The Dow Jones News Service and the Wall Street Journal’s first editor. As editor, Mr. Dow composed pieces for the Journal based on his stock market insights. Never wrote his own book. Although he published his thoughts in several articles, his writings were in many respects the foundation of modern technical analysis. Mr. S.A. Nelson, who was also a writer, did not publish Dow’s works until after his death in 1902. The phrase “Dow Theory” was coined by him initially, and it has evidently stayed. William Peter Hamilton, editor of the Wall Street Journal, arranged Dow’s work into a general framework in his book The Stock Market Barometer, published in 1922.
Further elaboration of the Dow Theory by Robert Rhea
Robert Rhea, however, standardized Dow’s work into standards that are still utilized today. Arthur A. Merrill, a distinguished technical analyst, included a brief history of Mr. Rhea in his book Behavior of Prices on Wall Street. Due to an airplane accident that occurred during the first World War, Mr. Rhea was bedridden from 1918 until his death. In Colorado Springs, he began studying Dow concepts, initially as a pastime and subsequently as a lucrative profession. His own riches increased as a result of the implementation of his (Dow) ideas. Throughout the most of the 1920s, he held long positions in stocks; he was stockless at the time of the 1929 market crash and sold short for two years. The vast majority of his achievement was attributed to Charles Dow’s theories.
Charles Dow created an index comprised of the leading industrial corporations of the day. He believed that by following the “correct” stocks, a barometer of business trends could be created. Initially, many of his efforts were aimed at creating an average price.
He was ordered back to the drawing board to reassess his strategy after achieving less success than he desired. He reasoned that a second group would be required to validate the movement of the industrials, so he created the Dow Jones Railroad Averages, comprising of 20 stocks. The reasoning was obvious and very reasonable. The industrial firms with which he initially worked “produced” the goods that drove the economy, but it was the trains that brought those items to the public that allowed sales to occur. In the United States, railroads were the primary form of transportation at the time. The railroad served as a secondary check for the industrials. Therefore, in a perfectly functioning bull market, both industrials and rails would be moving in the same direction and reaching new highs simultaneously.
Publishing of the first Daily Moving Averages
The Wall Street Journal began publishing the “Daily Movement of Averages” for the first time on October 7, 1896, along with an average price for both the 12 industrials and the 20 railways. As a matter of fact, the initial closing numbers were 12 Industrial $35.50 for 20 Railways $48.55
There are many of excellent biographies of Charles Dow, but for our purposes I will focus on the highlights. Dow had a variety of guiding principles, but I believe the most significant was that closing prices should reflect the current sentiments of all investors regarding stocks. Aside from acts of God, such as wars or earthquakes, etc., the current closing price reflects the collective thinking of investors. In other words, price provides us with knowledge. By the end of the trading day, everyone who desired to express their opinions and analysis had done so. Everyone who want to buy or sell shares on the open market has had the option to do so. In theory, the closing price of a stock reflects the aggregate of everyone’s expectations for that item.
Charles Dow also believed there were three periods of stock market trends.
- Primary bull and bear stage spanning over a year and establishing the general direction of the market.
- An intermediate phase lasting 4–6 months that acts as counter moves to the longer term move.
- A short-term phase, lasting a few days to a few weeks, that was deemed noise.
In his works, he equated these stages to the ocean, which, despite being a cliche, is still a highly effective metaphor after all these years. The principal move is the incoming or outgoing tide, the intermediate moves are the waves that comprised the tide, and the short-term moves are the foam on the waves’ surface.
Equally insightful were Mr. Dow’s additional observations. astonishing when you recall he made these results in 1900–1902. He added that volume verifies price movements.
When seen from the perspective of supply and demand, this is the identical belief contained in every economics textbook ever written. If the public believes that a stock’s price will increase, then the amount of stock being purchased must increase to reflect this demand. Mr. Dow believed, as a result, that an increasing volume pattern amid a rising price trend was the indication of a good stock. Importantly, he also observed that the volume decreased during periods of normal retrenchment. Although he viewed volume as secondary to price, it was nonetheless a crucial component of his theory. He believed that an increase in volume during a stock’s collapse could be indicative of a major market peak. In a modest downturn, demand should gain the upper hand due to a slowdown in supply, not an increase in supply. He also believed that a rally lacking in volume was suspicious. A price increase would seem to indicate that there is optimism surrounding a stock, which should attract purchasers. If, on the other hand, we observe a stock rising on little volume, we must consider that the rally may be short-lived. Again, I believe that he was observing the fundamental law of economics, which stipulates that the principle of supply and demand will dictate price behavior.
Obviously, he believed that the industrial and railroad averages must coincide. Without the railroads, the industrials’ ascent to unprecedented heights was cause for anxiety. This is only one of his conclusions, but I believe it is the one fact that most investors are most aware of when discussing the Dow Theory.
Many people today believe that Dow’s Theory may be antiquated and extremely slow to adjust to changing market conditions. This may or may not be accurate, but it remains a reliable strategy for avoiding severe drops or missing major gains.
Dow Jones Transportations Index
The last time the Dow Rails Index was replaced was on January 2, 1970, when the Dow Jones Transportations Index was introduced. In this new index, nine railroad firms were eliminated and other, modern forms of transportation, including trucking and airline stocks, were added. Prior to that time, the DJRs consisted solely of twenty identical railroad issues. For me, the 1970 version still works fairly well, but if we revisited the index with an eye toward modernizing its function, we might be able to improve a terrific tool.
By adding a few service sectors such as the Internet or Bio-tech Index to the industrials and perhaps something from the information superhighway to the transportations, we might give a very important piece of study a new appearance. There have been dozens of minor revisions over the years, the vast majority of which were correct. As they did in 1970, when they diminished the influence of the railways and modernized the index’s purpose, I propose a quantum leap on the scale. It is merely a notion.
Keep in mind that Mr. Dow’s work is regarded as the foundation of contemporary technical analysis. Without his early discoveries and the following work of individuals such as Nelson, Hamilton, and Rheas, technical analysis could have taken an entirely different direction.