It’s time for a history lesson.

As you know, we at use technical analysis as part of our trading and investment decision making. The history of technical analysis dates back to the early 1900s with a guy named Charles Dow.

Charles Dow

Charles Dow (1851-1902) was the founding editor of the Wall Street Journal and along with business partner and statistician, Edward Jones, is responsible for the creation of the index known as the Dow Jones.

From 1900 to 1902, Mr. Dow wrote a set of editorials which set forth his ideas of how the market worked. These articles become the basis of modern day technical analysis.

It was actually another market pundit named Sam Nelson who developed Dow’s editorials into the more formal structure of a book, with the help of Dow’s successor at the Wall Street Journal William Hamilton and market observer Robert Rhea.

Sam Nelson was the person who actually coined the term ‘Dow Theory’.

What is Dow Theory  

Dow Theory is considered by many as the foundation of what is now known as technical analysis.

Amongst many of Dow’s observations, he noted that there are three trends that are constantly at work on the market.

The primary movement: This is the strongest and most important movement. Dow believed the primary movement lasted at least four years.  

The secondary movement: This trend is the ‘trap’. It occurs as a significant change in trend in either a bull or bear market. However, because this reversal’s low (in the bull market) is higher than the last low, it is clear this is only the secondary trend in effect (and not an actual reversal). Dow believed this trend lasted from three weeks to three months.

The daily fluctuations: In Dow Theory, daily fluctuations are meaningless and cause only to distract.

The chart below illustrates the expectations of Dow Theory.

So, Dow Theory helps to define what a pullback is and what a change is in the overall trend. Using this as a guide, corrections should be viewed as buying opportunities (not the end of the world) until the most recent significant low has been breached. Once that happens, a greater downtrend has probably commenced.

The topic of Dow Theory has been around for over a century and the above only scratches the surface of what can be an extremely extensive topic. While it is not a perfect theory by any stretch of the imagination, it is definitely worth further reading.