What is the Dowa Theory?

As market participants, we are able to predict future price movements and market events with some probability. Dowa theory is based on assumptions such as:

• manipulation of stock markets is not feasible in the long term
• Market averages – indexes discount everything
• We are not able to predict the future with absolute probability.

Where did the Dowa Theory come from?

Dow theory was named after Charles Dow, an American stock market journalist who wrote articles on the stock market in the United States in the 19th century. He was one of the founders of the Wall Street Journal and creator of the Dow Jones Industrial Average. Above all, however, he was a successful stock market investor and market researcher, who put his insights and observations into a series of articles.

What was Charles Dow focusing on?

He studied price movements in particular rate charts and indices, averages reflecting the situation in industry and transportation in the United States. He called these averages key data. The author believed that they were a basic form of assessment of the US economy, which in turn was supposed to have a bearing on the stock market situation. In addition, he checked the behavior of the market based on emotions and speculation.

His actions led to a significant increase in the importance of averages in the analyses carried out by analysts and the great influence of derivatives on them. Indeed, they immediately became the most popular investment instruments in the world. These include U.S. indices, such as Down Jones, S&P 500, Nasdaq Composite, and the European DAX, FTSE, CAC40, WIG20, as well as the Nikkei-225 of Japan.

The basic premise, that is, the market moves in trends

Trends are the basis of market theory. They determine whether the stock market is in a bull market or a bull market. It is important to remember that trends are not equal to each other. According to Charles Dow, there are three basic types of trends:

• short-term
• medium-term
• long-term – this is the trend that earns the most money. It can last up to several years. For investor it is tiring mainly because of the duration and the time of profit realization. It is a time that does not require much commitment, but only waiting for the signal of termination.

The most important assumptions of the Dowa theory

According to Robert Rhea’s analysis of , Dowa theory is based on three basic assumptions:

• Market manipulation is only possible in the short term

What does this mean? First of all, the fact that long trends are not subject to manipulation, and even a group of people are not able to influence the markets in the long term. Sometimes currency rates or LIBOR interest rates are subject to manipulation. Keep in mind that stock markets are now hundreds of millions of transactions per day, which means that it is impossible to control all of this.

• Stock market averages discount everything

What does this mean? Indexes depicting the broad market show the mood of the markets. The situation of individual stocks should always be compared to the mood of the broad market as depicted by stock market indices. As a result, during a bull market, even companies with worse fundamentals can go up, and vice versa. On the other hand, when there is a bull market then companies with solid fundamentals also lose.

Charles Dow defined it this way: “The market is not a balloon floating through the wind. The market as a whole represents the efforts of generally well-informed people to adjust prices to existing values in the not too distant future.”

• Dowa theory is not infallible

Unfortunately, as with many other ways to make money, this does not guarantee success. Instead, it must be adjusted with proper care and backed by numerous analyses.

Dowa theory, and the fundamental theorems

Robert Rhea also described the theorems of Dow theory, which are still current today and relate to stock price movements.

Assumption #1

It is based on the assumption that there are three movements in the market. The first is the main, long-term trend, which lasts from a few months to even a few years. In turn, the medium-term trend – which is a correction of the main trend – lasts from a few weeks to a few months, and the short-term trend lasts from a few days to a few weeks.

Assumption #2

It is based on the assumption that the bear market (so-called bull market) belongs to periods of intense declines in stock prices. This market begins in most cases with tests of new peaks with decreasing volume, which is associated with a period of distribution. It is usually associated with crises, economic slowdowns and the bursting of speculative bubbles, which can cause share prices to fall in the range of 20 to 50 percent.

Assumption #3

It assumes that a bull market (so-called bull market) is associated with a long-term upward trend. Stocks after a strong decline also begin to be attractive to big players. At this point, the allocation process begins. A bull market lasts most of the time for more than two years, and stock prices during this time rise about 77% since the last bull market.

Assumption #4

It means that higher-order corrections are considered to be declines in a bull market (bull market) or increases in a bear market (bear market), which last from a few weeks to a few months and are characterized by the abolition of the last movement between 33% and 66%.

So how do we use the Dowa theory?

First of all, it is worth remembering that this is a model that allows you to arrange the market into certain patterns that have been going on for years. It allows you to arrange the market into certain patterns. It starts with an allocation, the beginning of a bull market, then we come to the main trend and finally to the distribution. It is worth remembering that the most important main trends are extended, if only because of the action of central banks, pumping very large amounts of money into the market. The patterns themselves, however, remain the same.

In sum, it is worth using a very well-known saying by Warren Buffet, which implies that we should be afraid when the majority is greedy, and be greedy when others will be afraid.