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Posted on 8 April 2011 | 4,848 views

Charles Dow Used Dow Theory for Stock Market Prediction

Dow Theory, a forecasting system devised more than 100 years ago by Wall Street Journal editor Charles Dow is an old analytical approach to stock charts that makes it possible to accurately forecast stock prices by identifying trends.

The premise of the Dow Theory is simple: If shares of industrial companies that make aluminum, computers, planes, farm equipment and soft drinks are hitting fresh highs at the same time as shares of the transportation companies that deliver those goods via planes, trains and trucks, it signals that the market’s upward move is healthy.

When you look at a stock chart, first identify the peaks and valleys called “highs” and “lows.” To predict an up trend, which leads to higher prices in the future, look for a pattern of “higher highs and higher lows,” according to the theory.

This means that each peak is higher than the previous peak, while each low formed after a peak is higher than the previous low. Such a sequence is a trend that may continue indefinitely, allowing you to accurately forecast higher prices over time. A pattern of “lower highs and lower lows” is a down trend, which suggests prices may fall for an indefinite period of time.

It’s vital that more than one index shows similar signals in a close period of time, it is a sign that business conditions are moving in the indicated direction. Thus, rising stock indexes signal a new uptrend.

A weakness of Dow Theory is that its followers can miss out on big gains, because by the time the market sends a clear signal that the trend has changed from down to up, the market has already posted sizable gains.

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