Dow Theory: Nonconfirmations And New Highs

06/10/04 01:54:28 PM

by David Penn

As the Dow transports soar toward new YTD highs, the Dow industrials struggle to surpass the highs of April.

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

About a month ago I suggested in a piece for Traders.com Advantage ("The Return of the Son of Bearish Confirmations," May 13, 2004) that it if the Dow Transportation Average ($TRAN) followed the Dow Industrials Average ($INDU) below its March 2004 lows, then the markets would be providing their second bearish confirmation or second Dow theory "sell signal." Recall that the first bearish confirmation or Dow theory sell signal came when both Averages moved down below their February 2004 lows in a correction that culminated with the March 2004 lows. Since those lows, both Averages have rallied powerfully. But the path of those rallies has differed in significant ways -- ways that are increasingly worth noting as both Averages move closer and closer toward resistance.

Both Averages moved up in late May and into April in three-stage rallies. In the case of the Industrials, the first peak came in early April and was followed by a lower peak later in the month. In the case of the Transports, the first peak in early April was followed by a higher peak later in the month. There is no special significance to this "alternation." At best, the Industrials failed to confirm the higher high of the Transports in late April. However, as I have tried to emphasize in a number of articles for Traders.com Advantage and Working-Money.com, a non-confirmation is, essentially, a Dow theory non-event. Arguably, the rally was in trouble by late April because of this non-confirmation. But there is nothing in Dow theory that insists this be the case.

Figure 1: Next stop: the year-to-date highs�at least if the bulls have anything to say about it.

Graphic provided by: Prophet Financial Systems, Inc..

Nevertheless, both rallies did run out of steam in late April (there was a stochastic divergence with regard to the Transports, but no additional clues other than the "non-event" mentioned above). As both Averages corrected, the Industrials fell far enough to exceed the March 2004 lows on the downside, yet the Transports failed to do so -- never closing below 2800 (the March 2004 lows in the Transports were about 2750). This set up another non-confirmation or Dow theory non-event. Again, it might mean that the decline was in trouble (as was the rally when the last Dow theory "non-event" occurred in late April). But Dow theory suggests no immediate action and, moreover, the Dow theory "sell signal" would still be considered intact.

Figure 2. A close above the April highs in the Industrials would provide a Dow theory bullish confirmation.

Once again, the declines ended shortly after the non-confirmation/non-event and the Averages rallied again. And it is in this rally that traders and investors found themselves in early June. The strength and suddenness of the rally has no doubt taken traders and investors by surprise -- and it is hard to doubt that at least a part of this rally is not the result of short trades being called back to the barracks. Still, real or apparent, short-covering-based or authentic, the rally in the Industrials is currently headed toward support at the April highs, while the rally in the Transports is making mucho headway toward the January/year-to-date highs.

Much will hinge on how these Averages deal with these looming resistance levels. Right now, it is worth watching to see if another non-confirmation develops -- this time, between the Transports' ability to close above their April highs and the Industrials' failure -- thus far -- to do the same. If the Industrials do close above their April highs, such an action would represent a bullish confirmation which would, at a minimum, challenge the bearish confirmation/Dow theory sell signal from March.

David Penn

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

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DOW THEORY

Dow Theory: Nonconfirmations And New Highs

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