THE HAnDbook of TEcHnIcAl AnAlysIs
laid out in Rhea’s book The Dow Theory. It was Robert Rhea’s work that really
developed Dow’s Theory and laid the basic foundation with three important as-
sumptions. The first is that the primary trend is not susceptible to manipulation,
although there is a possibility that it could occur over the shorter term. Rhea’s
second assumption was that the averages discounted everything and that price
is a reflection of all information. Finally Rhea proposed that Dow Theory itself
is not perfect and that investing according to its principles will not guarantee
profitability. At most, it should be regarded as a set of guidelines for investing.
Dow published, in 1884, a stock market average of 11 stocks that he later
developed into a 12‐stock Industrial Index and a 20‐stock Railroad Average. Dow
wanted to create an index of stocks to better reflect the general action of the mar-
kets instead of trying to gauge market behavior via individual stock action, which
was at the time fairly erratic and open to manipulation. The index was meant to
average out or smooth these erratic price movements. The action of the averages
was meant to act as a barometer of the current market environment.
Since then, the 12‐stock Industrial Index has gradually evolved into 30 stocks
and is known today as the Dow Jones Industrial Average. The Railroad Average is
known as the Dow Jones Transportation Average.
2.2 Basic Assumptions of Dow Theory
There are six basic tenets of Dow Theory, namely:
- The averages discount everything.
- The market has three trends.
- Primary trends have three phases.
- A trend persists until its reversal is indicated.
- The averages must confirm one another.
- Volume must confirm the trend.
In addition to the six basic tenets, only closing prices are recognized in Dow
Theory.
the averages Discount everything (pricing in Information)
It is believed that the markets discount everything, except acts of God. This
means that the market is the end result of all participatory action, which rep-
resents all information that may be known to the markets. The mechanism by
which information is known to the market is that of actual participation via
capital injection. Although the market cannot discount unexpected events, that
is, acts of God or unknown information, it can absorb, react, and adjust to
market shocks fairly rapidly. The pricing of all known information need not be
instantaneous or be driven by rational participants. There is also no requirement
that all participants always act on all information all of the time, or that they
react in the same manner.
Figure 2.1 depicts prices declining before September 11, 2001. Is the market
trying to discount information that is not as yet known or is it merely coincidental?
