Dow Theory Divergences

02/05/04 12:44:18 PM

by David Penn

As the Transports plunge toward multi-month lows, what happens if the Industrials fail to follow suit?

Security: $TRAN, $INDU
Position: N/A

The other way of asking this question is this: Does the crashing Transports index mean that a crash in the Industrials is only a matter of time? In fact, this was probably the way that most investors and traders looked at the massive selling in Dow transport stocks, a sell-off that took the Transports down from nearly 3100 to about 2851 (an 8% drop). Because of the way that many people think of the relationship between the Transports and Industrials, this mini-crash was likely the source of not a little anxiety among those clinging to hopes that the bull market in stocks is not yet over.

The reality of Dow theory then comes as somewhat of a relief to those equity bulls. As I discuss in a soon-to-be posted article for Working-Money.com, whatever an individual Average does is not especially relevant (from a forecasting perspective). What is most relevant -- and what is meant by the tenet of Dow theory that insists that "the Averages must confirm" -- is that no significant movement in the Averages can take place unless both Averages perform the same movement. One Average, for example, moving up while the other Average moves down is a non-confirmation (or a divergence, if you prefer). But, as Edwards and Magee point out in their Technical Analysis of Stock Trends, a non-confirmation is neither bullish nor bearish. It is simply a non-confirmation, and the prevailing or pre-existing trend should be considered intact until both Averages are moving together -- up or down.

Figure 1: The decline in the Transports has almost taken out the November 2003 lows.

Graphic provided by: eSignal.

Let's take a look at the declines in the Transports over the past eight days. This 8% drop has been a major event for holders of transportations stocks and shouldn't be understated. After breaking down beneath the late December/early January consolidation range, the Transports went on to break its 50-day EMA, as well. But the bears were hardly finished; the December lows at 2910 were broken to the downside only two days afterwards. The November lows at 2837? Still intact but, as of this writing with the Transports trading at 2851, it is not difficult at all to imagine a closing low in the Transports below the November lows -- only 14 points away.

Figure 2: The Dow Industrials remain in a trading range and have yet to join the Transports' collapse.

The price movement of the Transports is even more striking compared to the price movement in the Dow Industrials. Not only have the Industrials not dropped beneath their December or November lows, but also they haven't really come close to testing their 50-day EMA. The late December/early January trading range that provided zero resistance to the collapsing Dow Transports has, so far, helped keep the Industrials afloat. In fact, even the low of that end-of-the-year consolidation range has yet to be tested.

So what's ahead? The Industrials are experiencing, at a minimum, an oversold bounce, with the stochastic at about 27. The MACD histogram is similarly in oversold territory, further underscoring the notion of a short-term lift in the Industrials. With regard to the upside, watching to see how swiftly the Industrials move from oversold to overbought will be one indication of how much progress to the upside can be expected. The last time the Industrials were this low in terms of the stochastic was the great buying opportunity back in late November 2003. The rally that ensued from that opportunity was worth a thousand points in the Dow. This rally "it should be said" was confirmed by the Transports.

With regard the downside, the biggest question for the Industrials is whether or not they will confirm the declines in the Transports -- namely, by taking out any of its recent monthly lows. In an odd way, the farther the Transports descend at this point, the more dramatic (and, potentially, less likely) any confirming move from the Industrials would have to be. Interestingly, Jim Cramer, markets commentator for TheStreet.com, recently announced to his radio audience his preference for continued declines in the transportation stocks, among others. (Cramer noted that the Transports got "hammered" and that he was rooting against them. . .) His thesis was that the stock market required a certain volume of "bad news" to keep the Federal Reserve's cash-rate raising finger off the rate-raising button. But could it be that Cramer, the ultimate insider and market fundamentalist, has found himself in sync with the decades-long Dow theory, the Alpha (if not the Omega) of technical analysis?

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Dow Theory Divergences

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