The Dow Theory focuses on market trends. Markets experience primary trends that last a year or more, such as bull or bear markets, and secondary trends that are smaller movements, such as market corrections.
The tenet of Dow Theory is that a trend will continue until it is signaled by a reversal. A reversal is defined as a series of consecutive higher highs and lower lows.
Historical Trends
In the beginning, the Dow Jones was a tool to help Americans make sense of their stocks. At the time, stocks were not a popular form of investment; bonds were the most common way people chose to invest their money. Charles Dow created the average to show the general trend of the stock market. He used a list of 12 stocks and divided the total price by that number to produce an arithmetical average that represented the overall market trend. Since then, the list of stocks has changed and the divisor has been adjusted to compensate for stock splits and roster changes at companies.
A primary trend remains in effect until there is evidence that a force, such as an economic change, causes it to reverse. When a reversal is detected, the index will create successive peaks and troughs in the opposite direction of the prior trend. This is called a correction.
Generally, the Dow tends to be more volatile than other indices because the prices of the individual stocks that comprise it are more sensitive to day-to-day news. For example, a company’s quarterly earnings can greatly impact its stock price, and this will in turn influence the Dow Jones.
Another factor is that the Dow Jones is a weighted index, meaning that the stocks with the highest dividend yields have a greater influence on the average than those with lower yields. This is why high-dividend stocks such as AT&T and Coca-Cola are prominent members of the Dow Jones.
The Dow Jones is also a leading indicator of the overall economy in the United States, and it has been seen as a sign of global confidence. It has a direct correlation with the GDP of the United States, although this is not always the case in the short term.
The history of the Dow Jones shows that it has exhibited several parabolic trends over its lifetime. For example, it entered a parabolic stage after the crash of 1929 and entered a second one in the 1970s. The index is currently in a third parabolic phase and may enter the fourth if it reaches the top of its 100-year channel in 2020 or earlier.
Technical Analysis
The objective of technical analysis is to identify profitable investment opportunities using the patterns and statistics observed in asset price movements and supply and demand activity. Technical analysts use charts and other tools to track market trends, and look for specific signals that indicate a change in trend direction. Charles Dow, the financial journalist behind the Dow Theory, developed a framework for analyzing market trends which still forms the basis of modern technical analysis.
The Dow Theory is based on the belief that the market has discernible cycles which repeat themselves over time. The length of a cycle depends on the individual market, but it usually lasts four years and may extend up to 10 years. Identifying the current phase of the cycle is the first step to understanding how to read the Dow Jones.
Dow’s theory postulates that a market has discernible trends that can be analyzed by studying the prices and volume of stocks over a specific period of time. The trend can be identified as either bullish or bearish depending on whether it rises or falls over the course of a given period. The trend is then broken down into a primary, secondary, and minor trend. It is also important to consider the effect of the economy on the market in order to understand how to interpret the Dow Jones.
Another key aspect of the Dow Theory is that to confirm a new trend, the movements of two different market averages must be in tandem. This is similar to how the tide flows in and out of different parts of the beach. If the Dow Industrial and Railroad Averages, or DJIA and DJTA for short, both reach a new high at the same time, then it is a sign that a reversal of the trend is underway.
Finally, it is important to note that the market discounts everything. This is in line with the efficient market hypothesis, which states that market prices already factor in all possible information. Therefore, the movement of a stock’s price should reflect everything that has or will affect it in the future.
Fundamental Analysis
Unlike technical analysis, which is used to analyze trends in the market as a whole, fundamental analysis looks at individual stocks and their potential for growth. This involves studying the financial ratios of a company and comparing them with those of rivals. It also includes reading press releases and annual reports to find out how the company is doing. This type of analysis requires a thorough understanding of accounting and economics.
A key factor in conducting fundamental analysis is determining the intrinsic value of a stock. This can be done by looking at the company’s financial reports, assessing its competitors and analyzing its business policies. Investors use this information to determine whether a stock is undervalued or overvalued and make investment decisions accordingly.
One of the most important aspects of Dow theory is its belief that different market indices must confirm each other, consistent with the notion that the market discount everything. This is why it is important for traders to look at several different indexes when analyzing the markets. If one index shows a new primary upward trend while another remains in a downward trend, it is likely that the former is simply correcting its mistake and a reversal may not be imminent.
On the other hand, if several indexes show an upward trend at the same time, it is probably a safe bet that a major reversal has taken place. A consistent pattern of higher highs and lower lows over a one-month, two-month or three-month period is a clear sign that a primary upward trend has begun.
Traders can also use the historical trend of the Dow Jones to determine the general direction of the market over the course of a year or more. It is important to remember that the average changes in yearly closing prices reflect the influence of various events and developments. For example, a spike in yearly closing prices might reflect the impact of a new tax law or interest rate change. This can have a significant effect on a company’s profitability and stock price. As a result, it is important to consider all the factors that might affect the market before making a decision to invest in a particular stock.
Bottom Line
When analyzing the historical trends of the Dow Jones, investors should pay attention to both economic and technical factors. Generally speaking, a stock market advance is most likely to be successful if it is accompanied by an increase in economic activity and a decrease in supply. This is referred to as a “Goldilocks” environment.
If one of these conditions is missing, the stock market may experience troublesome price swings and even a decline. The technical analysis approach to determining a trend involves the use of the efficient market hypothesis. This theory states that asset prices reflect all available information, including earnings potential, competitive advantage and management competence. Investors should therefore be able to predict future performance based on current information.
Traders should also examine the various sectors in the market. The market divides sectors into groups, or industries, that are influenced by the same factors. The most common of these are consumer discretionary, financials, energy, industrials and technology. The broader groups are further broken down into subsectors that are more specific, such as healthcare and utility. As a result, the overall economy influences the stocks of individual companies, which in turn influence each other’s performance.
The prevailing economic conditions are the primary driving force behind the performance of the Dow Jones. Aside from these, political events can have an impact on the market. For example, midterm elections for the House and Senate can have a direct effect on policy and spending. Nevertheless, it is often difficult to determine how the outcome of these events will affect the market.
The Dow Jones is a stock index calculated by S&P Dow Jones Indices LLC (“SPDJI”) based on the prices of 30 industrial stocks. Other Dow Jones averages include the Dow Jones Transportation Average (DJTA), based on 20 transportation stocks; and the Dow Jones Utilities Average (DJUA), based on 15 utility stocks. These averages are commonly used gauges of the American stock markets. S&P, Dow Jones and their respective affiliates do not sponsor, endorse or sell investment products based on the DJIA, nor do they make any representation regarding the advisability of such products.
Conclusion
Analyzing historical trends of the Dow Jones Industrial Average (DJIA) can provide insight into the performance of the stock market over time. The DJIA has experienced significant fluctuations and growth throughout its history, with periods of volatility and economic crises as well as periods of stability and expansion.
Some notable historical events that have impacted the DJIA include the Great Depression, the dot-com bubble, the 9/11 terrorist attacks, and the 2008 financial crisis. In general, the DJIA has experienced a long-term upward trend, but there have been periods of decline and stagnation as well.
Investors should keep in mind that past performance is not a guarantee of future results, and the stock market can be subject to a wide range of factors that can impact performance.
By analyzing historical trends and patterns, investors can gain a better understanding of how the stock market has performed in the past and make more informed investment decisions.
FAQs:
Q: What is the Dow Jones Industrial Average (DJIA)?
A: The DJIA is a stock market index that tracks the performance of 30 large-cap companies listed on the New York Stock Exchange (NYSE) and the NASDAQ.
Q: What are some notable historical events that have impacted the DJIA?
A: Some notable historical events that have impacted the DJIA include the Great Depression, the dot-com bubble, the 9/11 terrorist attacks, and the 2008 financial crisis.
Q: Can historical trends of the DJIA predict future performance?
A: Past performance is not a guarantee of future results, and the stock market can be subject to a wide range of factors that can impact performance. However, analyzing historical trends and patterns can provide insight into how the stock market has performed in the past.
Q: How can investors use historical trends to inform their investment decisions?
A: By analyzing historical trends and patterns, investors can gain a better understanding of how the stock market has performed in the past and make more informed investment decisions. However, it is important to also consider current economic conditions, global events, and other factors that can impact the stock market.
