DJIA Diffusion Index Falls

02/16/11 08:42:32 AM

by Alan R. Northam

The Dow Jones Industrial Average Diffusion Index suggests that as the market continues to rise, it is doing so on fewer and fewer of its components.

Security: .DJI
Position: N/A

According to Martin Pring in his book "Technical Analysis Explained," a diffusion indicator is an oscillator made of a basket of securities that make up an index and often measures the part of the market that is heading up. "An example might be the percentage of the 30 stocks comprising the Dow Jones Industrial Average that are above their 30-day moving averages," Pring explains.

The statistical diffusion indicator in Figure 1 is an oscillator that moves between zero and 30, with 30 representing the number of securities making up the Dow Jones Industrial Average (DJIA). The indicator measures the number of the Dow stocks whose 50-day linear regression slope indicator is above zero and whose 50-day R-squared indicator is above its critical levels. Thus, this statistical diffusion indicator is made up of a basket of stocks that individually are in strong intermediate-term uptrends. The current reading of 20 indicates that 20 of the stocks within the DJIA are still in strong uptrends.

FIGURE 1: DJIA DIFFUSION INDEX, DAILY. This figure shows the DJIA diffusion index, a developing head & shoulders pattern, and the linear regression trendline along with its upper and lower channel lines.

Graphic provided by: MetaStock.

From mid-August 2010 forward, it looks as if the diffusion index is forming a head & shoulders pattern, so I am using a time frame that included the length of this pattern and chose a 130-day time period. I then plotted the linear regression trendline with a 130-day time period. I also plotted the upper and lower linear regression channel lines at plus and minus one sigma. This means that 83% of the movement of the diffusion index has been above the lower channel line. So a move below this channel line would be a significant event.

What I also found interesting is that the lower channel line is also moving along the neckline of the head & shoulders pattern. Thus, this makes a move below the lower channel line even more significant. A move below the lower channel line would signal a reversal in the direction of the diffusion index from an uptrend to a downtrend, implying that the trend of more and more stocks making up the DJIA is continuing to become weak over their individual intermediate-term trends, thus weakening the uptrend of the DJIA itself.

Note that the lower channel line crosses 19 on the right-hand vertical scale. This is an indication that all that needs to occur is for two more stocks to weaken over their intermediate-term trends to cause the diffusion index to cross below its lower channel line, reversing the trend from up to down. Note that today, two stocks weakened, forcing the diffusion index to move down by two stocks.

I have also plotted the DJIA in the the background for reference. I also added a blue vertical bar marking the beginning of February 2011. This shows that from the beginning of February, the DJIA has continued to move upward on the strength of fewer and fewer of its individual component stocks. The fact that the Dow continues to push higher may be construed as a sign of strength, but the fact is that it is only moving higher on the strength of fewer and fewer stocks and is in reality a sign of weakness and not a sign of strength.

In conclusion, the statistical analysis of the DJIA diffusion index suggests that the uptrend of the DJIA continues to weaken. It also shows that it may only take two more individual stocks within the index to weaken over their intermediate-term trends to reverse the trend of the diffusion index from up to down. A reversal in the trend of the diffusion index would then indicate that the trend of the individual stocks making up the DJIA is to become weaker and weaker over their individual intermediate-term time periods. This continuing weakness would then eventually lead to the DJIA reversing its intermediate-term trend from up to down.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.

	Garland, Tx
Website:	www.tradersclassroom.com
E-mail address:	inquiry@tradersclassroom.com

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