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The Foundations of the Dow Theory

Updated on April 8, 2008

The Foundation of the Dow Theory

Dow Jones is the company that publishes The Wall Street Journal. It was founded towards the end of the nineteenth century by Charles Henry Dow and Edward Jones. They started by handwriting news sheets, which were rushed to subscribers by messenger boys. These news sheets became The Wall Street Journal, the first edition of which appeared in 1889. Charles Dow became very well known for his editorials, and is famous today for his financial insights as published during his life.

However, Dow Jones has also become a famous indicator of prosperity in the U.S. markets. The company actually issue many indices, but the most famous is the Dow Jones Industrial Average, or DJIA, which is what is meant when people talk of the Dow going up or down. Charles Dow originally calculated and published a stock average in 1885, and this was mainly composed of railroad stocks. In 1896 the Dow Jones Industrial Average made its debut, and in this case it excluded transportation stocks and utility companies, for which Dow created other indices, but included, as today, virtually any other type of company that the editor thought appropriate.

The first Dow Jones Industrial Average was composed of twelve stocks, only one of which is still in the index today. That company is what is now called General Electric. The index is updated with changes of company from time to time, at the discretion of the editor. There have been 30 stocks in the index since 1928, and the last change was in February, 2008, when Bank of America Corporation and Chevron Corporation replaced Altria Group Inc. and Honeywell International Inc. Previous to that, the companies had not been changed since 2004.

The editors are very careful when they make substitutions, realizing that the Dow Jones Industrial Average is perhaps the most followed index of financial prosperity in the world. They try to make sure that all types of industry are represented fairly, to reflect the current business emphasis, and in this latest change chose banking, as they felt that the financials industry was under-represented, and picked Chevron because of the growing importance of the oil and gas industry to the world economy. Altria Group was dropped following some spinoffs which meant it was left as a purely domestic tobacco company, and Honeywell was taken out because it was the smallest of the industrials, and the role of the industrials relative to the overall stock market has been diminishing recently.

You may be wondering what happens to the index when the composition of the companies changes. The answer is that, again, the editors, being very conscious of their responsibilities, take great care to introduce the companies so as not to affect the value. They do this by applying weightings to each stock price. The weightings of existing stocks do sometimes change, for example if there is a rights issue, or some other influence on the stock value. One of the criticisms of the Dow Jones Industrial Average is that the weightings are based on the stock prices. Some people think that they should be based on the total market capitalization of the companies. However, despite only using 30 stock values, the DJIA has proved to be an indicator that is very consistent with the market as reflected by the Standard and Poor’s 500, an index with 500 shares, or the Wilshire 5000.

In 1999, there was a break with tradition. Founded in Wall Street, and still based there, the Dow Jones Industrial Average had been composed only of shares that traded in the New York Stock Exchange. In 1999 it was decided by the editors that two of the world’s leading technology companies should be substituted into the index, and so they incorporated Intel and Microsoft.

Charles Dow has been credited with the thought behind the Dow Theory, which purports to predict the stock market. Citing editorials that he wrote until 1902, the year he died, devotees use the system that has been developed to predict the movements of the market. Charles Dow urged investors to consider the stock’s underlying value, its dividend yield, and close observation of market swings. The Dow Theory, in its most basic form, holds that the Dow Jones Transportation Average, another common index, must confirm the direction of movement of the Industrial Average for the trend to have staying power. William Hamilton, the Journal’s editor from 1908 to 1929, may have been responsible for popularizing this theory, as he elaborated on it at length in his editorials. If you are interested in finding out more about the Dow Theory, you can find a good description of it in the free trading course available from www.insightsupport.com .

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