Dow Theory: An Effective Tool for Technical Analysis or Outdated in Today's Markets?
Dow Theory is a widely used method for technical analysis to determine the overall trend in the stock market. Charles Dow, founder of Wall Street Journal, created it. It is based upon the principle that the stock markets move in three distinct trends: primary, secondary and minor
Although Dow Theory is praised for its ability identify long-term trends in the market, there have been many criticisms. We will be discussing some of the problems with Dow Theory and how they affect its relevance in today’s fast-paced, ever-changing markets. Only limited applicability to faster moving markets and shorter timeframes.
Dow Theory has several flaws. It is not suitable to be used in fast moving markets or for shorter time periods. A commodity trader may have to wait several months, or even years, for a buy signal or sell signal that is based on the penetration or peak of the primary bull or bear trends. Hedgers might have trouble finding counterparts to the trade. Capital risk can also be high if the stop-loss order is based on the motion in the primary trend.
Primary Trend Susceptible to Manipulation
Another problem with Dow Theory is the possibility of manipulation of the primary trend. The artificially bullish environment created by the central banks' monetary policy, which includes near-zero interest rate and stimulus packages, can be a positive for the longterm market. Participants have little to no fear of any untoward events. Markets are susceptible to manipulation, as showed by the recent Libor scandal and collective energy market rigging. In today's highly affected markets, Dow's primary reason for trading the primary trends is unfounded.
The Market Environment is not reflected in the Indices.
Today's markets are open to manipulation because most indices can be traded. For example, the VIX was intended to reflect market fear, but is somewhat destabilized by the high volume of speculative trades that affect the VIX. The physical gold price is also subject to heavy shorting by its ETFs (like the GLD) or its futures- and options contracts. These products were not available in Dow's day.
Only closing prices are recognized.
Dow Theory recognizes only closing prices. This ignores potential intraday ranges of large magnitude that could occur during the trading session. These crucial price rejection levels are completely ignored. There seems to be a conceptual conflict between the recognition of the smallest amount needed to close higher or lower and the discounting potential large and significant daily fluctuations. These are considered noise. Safety is assured by buy and sell signals based on primary trend. Proponents of Dow Theory argue that signals that are based on the primary trend make it safer to buy and sell, while detractors claim that they often occur too late in the trend and miss large parts.
It is difficult to identify a new primary trend.
It can be difficult to determine whether a retracement was part of a secondary response or the beginning of a primary trend in the other direction. If the market develops in a different direction than expected, it is riskier to invest based on the assumption that the retracement will only be a secondary reaction.
All Averages must Confirm One Another
The Dow Theory states that averages must agree. The demand for goods from industry is high in a healthy economy. This can be seen in the volume of transportation activity that goes into shipping these goods to consumers. So, if either the transportation or industrial averages are below normal and result in non-confirmation, it would be logical to suspect trouble.
Let us conclude.
Although Dow Theory is a widely used tool for technical analysis, there are some limitations and criticisms. It was created in a different time and market environment to today's, which has more manipulation, volatility, and complexity. It may not be as useful or effective today in the fast-moving, dynamic markets.
One of the main criticisms of Dow Theory is its application primarily to equity markets. Its susceptibility for market manipulation, disregarding intraday ranges, price rejection levels and lack of ability to identify new primary trends. Due to the changing market composition, the requirement of confirmation between industrial and transport averages may not be as relevant.
Although Dow Theory is still a useful tool for investors and traders, it's important to recognize its limitations and look at other technical analysis methods that might be more appropriate for today's markets. The key to trading and investing success is staying informed, flexible, and open to learning new strategies and techniques.