Dow Theory

Dow theory was formulated from a series of Wall Street Journal editorials authored by Charles H. Dow from 1900 until the time of his death in 1902. These editorials reflected Dow’s beliefs on how the stock market behaved and how the markets work.
Due to his death, Dow never published his complete theory on the markets, but several followers and associates have published works that have expanded on the editorials to make them known as Dow Theory. Some of the most important early contributions to Dow theory were William P. Hamilton's "The Stock Market Barometer" (1922), Robert Rhea's "The Dow Theory" (1932), and Richard Russell's "The Dow Theory Today" (1961).
The Dow Theory is made up of six principles which help investors to better understand the price actions and the behavior of the stock market.

1. The Prices Discount Everything

The markets reflect all known information. Everything there is to know is already reflected in the markets through price. Price represents the sum total of all the hopes, fears and expectations of all participants. The unexpected will occur, but usually this will affect the short-term trend. The primary trend will remain unaffected.

2. The Market Has Three Trends

Dow has considered a trend to have three parts: primary, secondary and minor. Primary moves last from a few months to many years and represent the broad underlying trend of the market. Secondary or reaction movements last for a few weeks to many months and move counter to the primary trend. Daily fluctuations can move with or against the primary trend and last from a few hours to a few days, but usually not more than a week.

3. A Trend will Continue Until Definite Signals of Its Reversal

Primary movements represent the broad underlying trend. These actions are typically referred to as BULL or BEAR trends. Once the primary trend has been identified, it will remain in effect until proven otherwise. Markets might move in the direction opposite the trends for a short time, but they will soon return to prior move. There are reversal signals to look for.

The Yin-Yang Index is developed based on the above three Dow Theory principles and the CMBT Theory (Capital Market Behavior Theory) developed by Dr. Charlie Q. Yang. The other three Dow Theory principles are listed below.

4. Major Trends Have Three Phases

Dow states that there are three phases to every primary (major) trend, which is the most important trend to be paid attention to.

Accumulation phase – the first stage of informed investors to start entering the market with the belief that turning point is inevitable.
Public participation phase – in this phase prices start rising rapidly and economic news improves becoming more optimistic.
Distribution phase – this phase takes place when economic conditions and news reach their peaks. Many investors become more encouraged and public participation increases, as media keeps on publishing bullish stories.

5. Volume Must Confirm the Trend

Dow paid much attention to price action, because he considered the main signals for buying and selling to be based on price movements. Dow recognized volume as a secondary indicator, which played an important role in confirming price signals. In other words, the volume should expand in the direction of the primary/major trend.

6. The Averages Must Confirm Each Other

Dow stated that for having a valid change of trend, the Industrial and Transportation Averages must confirm each other. Both averages must exceed the previous peak to confirm the inception or continuation of a bull market. According to Dow, the signals did not have to occur simultaneously, but he believed that a shorter length of time between the two signals provided stronger confirmation.