Charles Dow was the editor (and part-owner) of The Wall Street Journal around the beginning of the 20th century.

Dow created the Dow Jones Industrial Average and the Dow Jones Transportation Average in the late 1800s to help track the economy. In his editorials, Dow wrote about the relationship between the two averages and how traders might use this as a framework for understanding the economy, market direction, as well as a forecasting tool.

The initial work Dow developed would later be refined into what is now known as the Dow Theory. And ever since then, it’s been used as an economic forecasting tool to make money trading stocks.

Some market-watchers might say that Dow Theory doesn’t hold up in today’s economic environment. But many other traders swear by it. So today, let’s take a broad look at how it works, how traders use it, and why it still matters today…

What Is Dow Theory? And How Do Traders Use It?

At its most basic level, Dow Theory is simple to understand. When both indices are moving in the same direction, a confirmed trend is in place. That serves as a signal for traders to become more aggressive.

Dow Theory is based on the premise that the economy grows when manufacturers are producing as much as possible. Economic growth, of course, translates into profits for these companies. And this can be seen in the performance of their stocks. But getting those goods to market requires the transportation industry to be growing. And that should drive the stocks of transport companies higher first.

Even in today’s technology-driven economy, traders still use Dow Theory to identify the direction of the major trend in the stock market. Movements in the two averages must confirm each other to show a trend change. To signal a bull market, both averages must rise above their most recent highs. A bear market signal is when both averages drop below their most recent lows. A move to a new high or low by just one of the averages is not a trading signal.

Dow ignored the smaller moves in the stock market. His goal was spotting only the primary trends that could last for months, not the short-term trends that unfold over the course of a few days. We can see an example of this in the chart below. When the stock market bottomed in March 2009, Dow Theory did not issue a buy signal until July of that year.

Why It Matters Today

For the example in the chart above, the buy signal was about 35% above the low. Traders missed out on significant gains, but still enjoyed more than 30% upside over the next year. As this example shows, Dow Theory signals will always be late. But it can give traders and investors alike a much higher degree of confidence when making decisions.

Although Dow wrote about his theory from 1900 to 1902, the ideas still work today. But like systems or market signals, they are not infallible.

Dow Theory signals continue to highlight major stock market moves. The system’s rules work well for trend followers who are comfortable missing the first part of a big move in favor of solid confirmation that a trend is in place.

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