Dow Theory

Welcome to the fascinating world of technical analysis. We begin this new series with Dow Theory and a bit of historical background.

Technical Analysis as a discipline began late 19th century, when Charles Dow, a Wall Street journalist, created two separate indices, Industrial & Railroad, to gauge the overall health of the economy. By that time, it was well known to the analysts that stocks rise & fall mostly together, but Dow’s concerted effort to objectively measure the state of economy by combining stock prices of corporations from large industries that defined the US economy was a revolutionary concept for that era. It is because of this visionary thought that today Charles Dow is considered as the father of technical analysis & the major US stock index is named after him.

But why two different indices were required? It is because railways were the major form of transport of that era & a booming economy was supposed to be reflected in bigger freight movement. The logic behind two indices was a sort of confirmation. According to his logic that will later come to be known as Dow theory, when Industrial made new high & that was confirmed by Railroad index, a new bull market was declared. Any divergence between the two is a suspect. Over the last century, component stocks of the Dow Jones Industrial Average (DJIA) have seen radical changes to retain the basic characteristics but GE is the only stock in DJIA today that found a place in Charles Dow’s list in 1897 as well. Railroad index is today renamed as Dow Jones Transport Index & it includes all other forms of transport stocks like aviation, shipping etc. After the death of Charles Dow in 1902, William P Hamilton collected & edited his works and published them as a formal theory. Later on Robert Rhea also contributed to this body of knowledge.

As mentioned earlier, Dow’s original intention was never to forecast stock prices but to gauge the health of economy. But today we use it in a very different manner. Is a theory that is well over hundred years old, good enough to help us analyze today’s market conditions? Have not the dynamics of the market changed over time? In our next issue, we shall take a brief look at the tenets of the theory itself and try to understand how it addresses these concerns.