FOOLISH FOUR PORTFOLIO
History of the Dow
Dow's Theory

By Randy Befumo (TMF Templr) and Alex Schay (TMF Nexus6)

Charles Dow had one goal in mind when he created the Dow Jones Averages: to measure the market as a whole rather than simply focusing on individual stocks. He wanted to make these Averages the foundation of a comprehensive theory that could be used to explain and predict general market movements. Dow was originally credited with creating the first general market average in July of 1884, although he later modified this and began to publish separate Industrial and Railroad Averages on May 26, 1896. These Averages are the foundation of Dow Theory.

What we know today as Dow Theory was actually posthumously attributed to Mr. Dow by S.A. Nelson in his 1902 book, The ABC of Stock Speculation. Dow never wrote a book on investments and confined his opinions to anonymous editorials in the Wall Street Journal. In Nelson's book, he clearly identified Dow as the intellectual force behind the Wall Street Journal, and, in fact, lamented that Dow never published a comprehensive text on "speculation". Nelson believed Dow's position at the center of Wall Street would have uniquely qualified him to write such a book.

In The ABC of Stock Speculation, the headings of chapters five through nineteen carry an asterisk with the accompanying simple footnote: Dow's Theory. As George Bishop notes, "Hardly an auspicious beginning for an appellation that has endured in the language of the market to the present day."

The Dow Theory contains nascent forms of both fundamental and technical analysis, as neither discipline had been fully developed during the infancy of the stock market. Many terms that are now considered crucial to technical analysis first appeared in Dow's Wall Street Journal editorials -- including the idea of primary, secondary, and tertiary "trends" lasting for different fixed durations. The irony here, of course, is that Dow was an avowed fundamentalist, propagating the notion that prices followed earnings and that balance sheets should be made public for all investors to see. Companies in this bygone era were not too keen on allowing investors to see what sort of cash, debt, or receivables they were carrying on their balance sheets.

Graham and Dodd in Security Analysis further credit Dow with the notion of accumulation and distribution, stating Dow believed "when movements of several weeks or longer are confined ... to a range of 5 per cent, a 'line' is said to have been formed suggesting either accumulation or distribution." One general market average was not enough for Dow to confirm accumulation or distribution. Dow wanted to have two averages "break out above the line simultaneously" to confirm accumulation, or "break out below the line simultaneously" to show distribution. It was this innovation that lead Dow to break his first general average of 1884 into two distinct averages.

Dow's Theory called for the creation of an Industrial Average and a Railroad (Transportation) Average as a way to confirm the general direction of the market. Using these Averages, one would be able to tell where the market was going if movements in the two separate Averages "confirmed" one another. If both Averages were moving upward and had broken through their previous highs, the stock market was headed even higher. If both Averages have broken through prior lows, then the market was going down. If only one Average had broken a previous high or low, or if both Averages were flopping around and not doing much of anything, no conclusion on general market direction could be reached, and it was assumed that the market would go sideways.

The reasoning behind this part of the Dow Theory is actually common sense, even if it does depend heavily on investor psychology. Dow thought that if industrial stocks were rising, then investors must think that they have great potential. If the railroad stocks are rising, then things must be looking pretty good for them. But, since railroads made their money by toting the goods of industrial concerns around the country, you could not say that the prospects for one group were good until the prospects for the other group were also good. In other words, the industrials could not thrive without increasing the business of railroads, and the railroads could not increase their earnings unless they were being deluged by shipment orders from industrial manufacturers.

Today, the tight links between the Industrial and Railroad/Transportation averages have dissipated. The Dow Industrials include many companies whose goods and services, for the most part, do not need to be shipped (e.g., AT&T, J.P. Morgan, and Walt Disney). Also, many Transportation Average stocks, like AMR Inc. (the parent company of American Airlines) or USAir, now focus on commercial travel, which is not directly tied to industrial production.

The impetus for revising the Industrial and Raiload Averages, as opposed staying with one general Dow average, was that they would be inextricably linked together. There is supposed to be a direct correlation between them in order for the Dow Theory to work. Although many modern purveyors have turned his thought into technical gobbledegook, the simple fact is that if Dow were alive today, he probably would reject any attempt to predict the market with his averages as they are now constituted. Dow Theory, as least as far as Dow crafted it to be, has absolutely no contemporary relevance. However, Dow's Averages live on and remain a fixture in the investment world, with the Industrials having become a measure for the market as a whole.

[For those interested in learning more about the Dow Theory, the most comprehensive text on the subject is Bishop's Charles H. Dow & The Dow Theory, available at most libraries.]

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 History of the Dow

  • The Dow 1884-1886
  • The Dow Today
  • Charles Dow, Revolutionary
  • Dow's Theory
  • Dow Jones Averages
  • Dow Mechanics