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DOW THEORY

Leading By Transports

06/29/06 03:04:51 PM
by David Penn

While both the Dow industrials and the transports have broken out above downtrend lines, it is the transportation average that is leading the fight to best the June highs.

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

"No valid signal of a change in trend can be produced by the action of one average alone." So wrote Robert Edwards and John Magee in their classic book, Technical Analysis Of Stock Trends. Edwards and Magee were referring to the maxim that "the two averages must confirm"—a staple of Dow theory analysis and a helpful guiding principle when trying to discern the movement of the industrials, the transports, or both.

FIGURE 1: DOW JONES TRANSPORTATION AVERAGE, DAILY. The transports confirmed the industrials' move below the May lows, but failed to confirm the industrials' move below the April lows.
Graphic provided by: Prophet Financial, Inc.
 
The industrials and transports started off in gear when both averages topped in early May. The May decline in both tested the April lows first in late May before breaking down and closing beneath those lows later in June. However, while the industrials also broke down below the March lows, the Dow transports failed to confirm that move. This set up a little-discussed nonconfirmation in the averages.

I have written before that Dow theory nonconfirmations are nonevents from a Dow theory perspective. I've drawn this idea from something else Edwards and Magee wrote:


There is an unfortunate tendency in "the street" to overstress any such divergence, particularly when it can be twisted into a favorable sign. The fact is that, in Dow Theory, the refusal of one average to confirm the other can never produce a positive signal of any sort. It has only negative connotations.


I interpret "positive signal" and "negative connotations" not as "bullish" or "bearish," respectively, but as "bearing interpretative value" or not "bearing interpretative value." A confirmation tells us something and a nonconfirmation does not. A colloquial way of putting it might be to say that confirmations clarify while nonconfirmations obscure.


FIGURE 2: DOW JONES INDUSTRIAL AVERAGE, DAILY. The combination of the transports' refusal to confirm the industrials' close below the March lows and positive divergences in the MACDH and stochastic for both the transports and the industrials suggests an opportunity to the upside.
Graphic provided by: Prophet Financial, Inc.
 
So in the case of the nonconfirmation in June, it is perhaps most accurate to say that the downtrend in the averages has been "obscured" by a nonconfirmation. At times, the haze of a nonconfirmation masks a reversal (as Tim Wood of cyclesman.com often has pointed out). At other times, the nonconfirmation is in a sense overridden by new market developments (that is, a move to a new high or low that is confirmed).

One way of reading nonconfirmations is to use other tools, such as the stochastic, to spot divergences that may help signal a near-term low or high. In the case of the Dow averages, both the industrials and the transports developed positive, month-on-month divergences in both the moving average convergence/divergence (MACD) histogram and the stochastic. While not mandating a bottom, this surplus of evidence suggests that a tradable low is in the making (or has been, in the case of the transports) and that the nonconfirmation between the industrials and the transports was likely a hint that the downtrend that both averages began in May had come to an end.


David Penn

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

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Date: 06/29/06Rank: 3Comment: 
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