Dow Theory Overview

The Dow theory evolved from the work of Charles H. Dow, who published a series of The Wall Street Journal editorials between 1900 and 1902 concerning market action. Dow used the behavior of the stocks market as a barometer of business conditions rather than as a basis for forecasting stocks prices themselves. His successor, William Peter Hamilton, developed Dow's principles and organized them into something approaching the theory as we know it today. These principles were outlined rather loosely in Hamilton's book the Stocks Market Barometer, published in 1922. It was not until Robert Rhea published Dow Theory in 1932 that a more complete and formalized account of the principles finally became available.

The Dow theory assumes that the majority of stocks follow the underlying trend of the market most of the time. In order to measure "the market," Dow constructed two indexes, which are now called the Dow Jones Industrial Average and the Dow Jones Transportation Averages. The Industrials were originally constructed from 12 (but now include 30) blue-chip stocks and the Dow Jones Rail Average, comprising 12 railroad stocks. Since the Rail Average was intended as a proxy for transportation stocks, the evolution of aviation and other forms of transportation has necessitated modifying the old Rail Average in order to incorporate additions to this industry. Consequently, the name of this index has been changed to Transportation Average.

It should be recognized that the Dow theory does not always keep pace with events; it occasionally leaves the investor in doubt and is by no means infallible, since small losses are sometimes incurred. These points emphasize that, while mechanical devices can be useful for forecasting the stocks market, there is no substitute for obtaining additional supportive analysis on which to base sound, balanced judgment. Remember, in weight of the evidence approach Dow theory is one piece of evidence.