Dow To The Moon!

05/31/05 08:23:26 AM

by David Penn

Higher lows in May suggest that both the Dow industrials and Dow transports are in gear to move higher as the summer season begins.

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

Ah, summer. The first barbecue ... the first sunburn ... the first thunderstorm ...

And, of course, the stock market query that never fails to arrive about this time every year: Will there be a summer rally?

I've been writing for Technical Analysis, Inc., for going on five years now. And every summer since then, I've heard this question raised and have paid close attention to the answer in the form of the ensuing market activity. And every year save the summer of 2003, that oft longed-for summer rally has remained elusive.

Will the summer of 2005 prove any more or less so?

Figure 1: DJIA. A positive stochastic divergence between the March and April lows in the industrials suggested that the six-week bear market might be coming to an end.

Graphic provided by: Prophet Financial, Inc.

The fact that the markets seem to be developing some upside momentum by the end of May is almost guaranteed to draw out the more bullish and optimistic among us--and no doubt their calls for a summer rally will not be far behind. From a "church of what's happening now" perspective, this is not without some reason. As the charts of the Dow industrials and Dow transports in Figures 1 and 2, respectively, show, there was a bullish, Dow theory confirmation in the fact that both the industrials and the transports set higher lows in May vis-a-vis April.

Had one of the two--either the industrials or the transports--failed to hold above the April highs, then some upside might still be possible. But the two Dow averages would have then created a nonconfirmation, which, while technically a Dow theory "nonevent," would have cast a bearish shadow over any rally that followed such a nonconfirmed move to the downside.

However, this has not been the case, as the industrials and transports have been very much in gear with each other. In fact, the two averages have been trading in tandem consistently since at least the December 2004 highs--which should mean that any divergence or nonconfirmation between the two could be significant. This is true even if, again, Dow theory warns us against putting too much stock in nonconfirmations. Recall that even in the event of a nonconfirmation, a confirmation of some sort in which the other average "catches up" to the other would still likely follow and provide a more actionable signal.

Figure 2: DJTA. No stochastic divergence between the April and May lows, the Dow transports nevertheless eked out a bullish positive divergence over the course of the second half of April.

Graphic provided by: Prophet Financial, Inc.

Looking forward, what should investors, speculators, and traders be wary of as the industrials and transports try to extend their advance into June? With the averages having set new highs for May, the next goal for both the industrials and the transports is to take out the April highs. While the internal dynamics of each average will determine how well they perform over the next few weeks, from all appearances it is the Dow industrials that might have an easier time of taking out its April highs than the Dow transports might. As Figure 1 shows, the industrials are a mere 16-odd points away from surpassing their April 2005 highs--after coming as close as eight points only a few days ago.

By contrast, the Dow transports have more like 130 points to go before even testing its April highs. That is no insurmountable distance for the transports at all, representing only a 3-4% advance from its most recent close. But high hurdle or no, the work ahead for the transports is significant compared to what the industrials face. And, of course, should one average take out the April highs and the other fail to do so, then traders would be faced with a nonconfirmation, one that would still require a confirmation move to the upside or downside to truly provide a sense of market direction in the near term.

On the other hand, should both the Dow industrials and transports take out the April highs, then the only objective left will be the big one indeed: the March highs that would represent a new high for the year.

Whether a trader actually believes that such a move is possible, a test of the year-to-date highs is simply what would follow logically from a successful breach by both averages of the April highs. As helpful as the big picture can often be, watching the Dow industrials and transports for confirming and nonconfirming moves is a game that seems best played one step at a time, with a clear awareness of the potential implications of any given confirmation or nonconfirmation. There were any number of signals heralding a bottom in mid- to late April (I've written about a few of them for Traders.com Advantage), and the confirming moves of the industrials and transports in May were certainly among them.

David Penn

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

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