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Published: October 25, 2004
The growing disparity between the Dow Jones Industrials
($INDU) and the Dow Jones Transports ($TRAN) is symptomatic of a market
that is profoundly split. How this divergence is resolved will be an
important clue as to whether another bear market is again on the
horizon.
Dow Theory has its origins in the writings of Charles Dow -- founder of
the Wall Street Journal and creator of the Dow Jones Industrial
Average. His Journal editorials pioneered technical analysis. On
his death in 1902, William Hamilton continued Dow's work, writing
editorials of his own until 1929. Robert Rhea then collected the work of
both of these men and used it as a basis to publish The Dow Theory in
1932. This book expounds many key principles of stock market analysis,
such as defining the nature of the Primary, Secondary and Minor trends.
The concept from this book that I am concerned with at present is --
"The Two Averages Must Confirm."
The two averages in Dow's time were the Industrials and the Rails. The
logic was simple: industrial companies manufactured the goods and the
rails shipped them. When one average recorded a new Secondary or
Intermediate high, the other average was required to do the same in
order for the signal to be considered valid.
If the two averages acted in harmony, with both reaching new highs or
lows in relatively the same time period, then the price action of each
was said to be confirming. If, however, one average went to a new high,
but the other average didn't follow suit, then there was bearish
divergence. If the opposite occurred, with one average reaching a new
low, but the other holding above a previous bottom, then the divergence
was bullish. Robert Rhea then analyzed these new highs or lows in terms
of the market's Secondary or Intermediate trend. The time frame of this
trend is considered to be at least three weeks and can last three or
more months.
At present, of course, the rails are now the Transports. Dow Theorists
argue that the principle remains valid. As such, they contend that the
activity of the Industrials and Transports provides a filter to detect
whether the stock market is in a healthy or unhealthy state.
Weekly charts of the Dow Jones Industrials and Transports are juxtaposed
below. I have started both charts near the end of the three-year bear
market in July 2002. Each Intermediate peak and valley is assigned the
same number so an entire "move" can be easily identified. Note
that at point 3, the Industrials made a higher low than at points 1 and
2, but the Transports at 3 made a lower low. This was important bullish
Dow Theory divergence and was a signal that a major change in trend was
taking place. Shortly afterwards, the bear market in both indices ended
with a triple bottom formation. Note the break in a multi-month
downtrend line. Also note how prices rose above the 30-week moving
average, which began to slope upward (thus beginning the stage
II advance I have written about numerous times in recent Swing
Trader issues).
Observe also that the downtrend lines were broken very
close to the same time in May 2004. Clearly, the two averages were
"in gear" with each other. This period of confirmation lasted
through point 4 in early January 2004 when both averages hit peaks, as
well as through point 5 in April when both recorded lower
Intermediate-term highs and lows.
Starting at point 6 in late June 2003, however, the divergence in the
two averages can be clearly observed. The Industrials hit a lower
Intermediate high than at point 4 or 5 -- the definition of a downtrend.
The Transports, however, not only bettered their previous peak at point
5, but also took out the peak of point 4. The activity of both averages
at point 7 reinforces the divergence. The Dow Jones Industrials remains
in a strong downtrend, whereas the Transports are hitting multi-year
highs. The Industrials are below a declining 30-week moving average and
the Transports above a rising one.
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Eventually this divergence will be resolved in one
direction or the other. This resolution will be an important clue as to
whether the current bull market will continue or a bear market will
ensue. For the Industrials to bullishly resolve the divergence, the
blue-chip gauge must exceed its daily peak of point 7, which occurred on
July 23rd at 11479.57. For the Transports to fail, the index would have
to take out its daily low on August 6th of 2966.08. The Industrials
would have to rise roughly +6% from current levels to accomplish this
feat, but the Transports decline almost -15% to penetrate the previous
Intermediate low. Neither of these scenarios seems likely in the near
future. If that proves to be the case, then this Dow Theory divergence
could persist for some time. When it is resolved, however, it is likely
to set the market direction for several months -- and perhaps even
several years.
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Please Note: The above article was merely a
small excerpt from an issue of our premium, short-term equity trading
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