The Dow Theory is certainly the most celebrated, complicated, and least-understood interpretation of market action, probably because neither Charles Dow, who founded the Dow Jones Company, nor any of his various disciples has ever defined the theory precisely.
In essence, the Dow theorists hold that there is a primary movement in the market at all times — a kind of basic tidal action.
Then there is a secondary movement, which might be likened to waves.
And finally, there are the ripples on the surface that represent the daily movements of the prices.
The Dow theorists contend that it is possible to tell when either the primary or secondary direction changes by comparing the actions of the various averages, such as the Dow Jones Averages.
When they move in the same direction for a given period of time, either up or down, they are supposed to indicate a significant change in the direction of the market, which will hold good until the two averages “confirm” each other again in an opposite direction.
This is what the “market experts” are talking about when the i.e. say “the rails confirmed the industrials” — or when they worry publicly about the failure of one to confirm the other.
Dow theorists contend that by their somewhat nebulous formula, they have been able to forecast every significant movement in the market for many years.
Other analysts, looking at the same set of facts, dispute the Dow Theory’s record.
They say it can only be made to look good when the forecasting has become history.
Nevertheless, many financial editors continue to expound the Dow Theory and various Dow disciples appear in the advertising columns from time to time, offering a letter service, usually short-lived — to explain the market action in Dow terms.
Very often, the investors will encounter what appears to be a striking contradiction between the news and the market reaction to that news.
There is one simple explanation for such paradoxes:
Let us assume that the stock market has “discounted” the news.
The big traders — “the people supposedly in the know” — were certain that i.e. a special dividend was coming, because the X Company’s profits had been increasing spectacularly.
They had already bought or sold in expectation of these developments, and when the actual news-breaks attracted public interest in the market, the professionals seized their opportunity:
They sold when others bought or bought when everybody else was selling.