Charles Dow began his career as a reporter specializing in business and finance. He was the founder of the Dow-Jones financial news service in New York and in 1889 he began a little newspaper called The Wall Street Journal. In particular, he wrote the editorials for the Journal and gained quite a following in the process. I’ve read a lot of these epistles, and although Charles Dow was attributed with the founding of the body of knowledge now known as Dow Theory, I can’t find a single instance where he ever referred to it as his theory. What’s more, his articles are the only written record with respect to his thoughts on the market. Unfortunately, he never bothered to write a book.

The crux of Dow’s philosophy has to do with two concepts: value and market “swings”. Value comes before the ‘swings’ in terms of importance. The swings, or shifts in direction, were often related to the value (or lack of it) present in the market place. The swings could be classified into one of three categories: primary, secondary, and tertiary and all going on at the same time. The primary trend was the main trend of the market and usually lasted years. The secondary trend was the counter trend movements that always occur in a Bull or Bear market and they could last months. Finally, the tertiary movements were the day-to-day movements that could occur for little or no reason. Value is another issue and it often outran the swings. Simply put, share prices would often go lower than one expected during a Bear Market and higher than one could imagine during a Bull Market. Dow often saw value in a market when the PER fell below 8 and likewise saw a lack of value when the PER exceeded 17. [Today’s PER for the S & P 500 stands at 20.58.] Another measure of value had to do with the dividend paid by the market. Six percent or greater offered good value while three percent or less left something to be desired. 

Charles Dow recognized that “the stock market is a barometer of the country’s and even the world’s, business,” and he set out to develop a theory that could effectively and consistently read that barometer. What’s more, the market is forward looking so his barometer would be of considerable help in reading the state of the economy six months or a year down the road. To use Dow’s own words “ the stock market is not trading on what is common knowledge today but upon the sum of expert knowledge applied to conditions as they can be foreseen many months ahead.”

Dow’s star burned bright but as is often the case, it didn’t burn for very long. He died at the relatively young age of fifty-two in the year 1902 and it was left to others to elaborate on his original thoughts. Two men in particular, William Peter Hamilton and Robert Rhea, made significant contributions to Dow’s original work. Hamilton introduced the concept of confirmation and non-confirmation. He believed that rallies/declines would continue their present course as long as the DJIA and the Transportation Index moved in tandem. In other words, every time the DJIA would make a new high/low, it would be necessary for the Transport Index to confirm by also registering a new high/low or vice-versa. If either failed to confirm the others new high/low, it meant that the tide and turned and the primary/secondary movement had come run its course.

Robert Rhea followed in Hamilton’s footsteps and continued to refine both of his predecessors’ works. Unfortunately, he suffered the same fate as Dow, dying well before his time. E. George Schaefer was next in line and believed firmly in Dow’s concept of value. He differed somewhat with Schaefer and Rhea in that he put more emphasis on value than he did on the pattern of the averages. Schaefer then added some finishing touches when he added the 200-day moving average, the short interest ration, Dow’s 50% Principal, and more. I especially find the 50% Principal useful when it comes to analyzing commodities. Here’s a real life example: the price of oil peaks at 71.87 and then makes a significant correction down to 56.59. There it stabilizes, builds a base, and begins to rally. Once it closes above 64.23, 50% of the correction, one can be reasonably assured that we will test the previous high. What follows is a mixture of Dow, Schaefer, and Rhea: