The January Reversal: 2B or Not 2B?

01/10/03 02:11:50 PM

by David Penn

New highs need follow-through in order to be trusted.

Security: $TRAN
Position: N/A

At the beginning of December, I noted in a Traders.com Advantage piece that both the Dow Industrials and Transports were under pressure (see "Dow Reversal?" Traders.com Advantage, December 5, 2002). In that piece, I was concerned about the Dow Transports' inability to confirm the higher high made by the Dow Industrials in late November. Since that time, both the Transports and the Industrials did indeed correct to a support level characterized by the November and December lows. This support was at about 8300 in the Industrials and 2265 in the Transports. Following my "Dow Reversal?" piece, the Dow Industrials fell approximately 8%, with the Dow Transports dropping some 6%.

Since that time, both the Industrials and Transports have rallied, giving the first few trading days of 2003 a bullish tone. However, before the bulls begin polishing their horns, it would be worthwhile to wait and see whether or not both Dow averages are able to take and hold meaningfully higher ground. What is "meaningfully higher ground"? In the case of both averages, this higher ground is represented by the highs of November--approximately 9050 in the Industrials and 2417 in the Transports. So far, the Industrials have failed to accomplish this; the current January rally in the Dow Industrials has--as of this writing--peaked out at the level of the October highs of 8800. The Dow Transports, on the other hand, did exceed their October highs with a close of 2422 on January 6th.

The Dow Transports' failure to follow-through after making a new high in January suggests the bear market rally of autumn 2002 may be over.

Graphic provided by: TradeStation.

In terms of confirmation, this is a troubling sign. Whereas the Transports failed to confirm the Industrials' higher high in late November, now it appears that the Industrials are failing to confirm the higher high of the Transports in January. Moreoever, there has been precious little follow-through on the Tranports' higher high. After closing at 2422 on January 6th, the Transports registered two days of lower closes and lower intraday highs. Although the Transports were rallying on January 9th, the day did not see a close above 2422--in other words, still no upside follow-through on the higher high.

This failure to follow-through with higher highs is the essence of what trader Victor Sperandeo refers to as his "2B Test" (see his "Methods of a Wall Street Master" and/or "Principles of Professional Speculation"; as well as my Traders.com Advantage articles on the subject, including "Two Takes on March Sugar's Top" from December 9th and "December Corn's 2B Test of Top" from September 13th). Deceptively simple, Sperandeo's 2B test methodology suggests that when prices fail to follow-through after making a new high, the likelihood of a reversal is significant. While Sperandeo encourages traders and speculators to use other market signals (indicators or fundamental data, for example) as opposed to committing resources solely based on the 2B signal, the 2B test of top (or bottom) remains a worthy strategy geared both toward catching trend reversals as early as possible, as well as in avoiding the infamous bull and bear traps.

So far, we see just such an example of a failure to follow-through in the Dow Transports. After taking out the highs of late November and late October early in January, the Transports retreated. While the Transports have not broken down beneath support by any means, the prospect of--at a minimum--a trading range between 2420 and 2265 looms largely. Of course, at worst, the failure to follow-through on the upside could be a hint of more significant downside risks. However, at this point it is sufficient to suggest that the case for a continued bull market in the Transports (which, incidentally, are already up some 20% from their October lows) is weaker as opposed to stronger than it might have been a few months ago. And if the Transports do indeed decline, Dow theorists will have to wonder whether or not the Industrials will be far behind.

David Penn

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

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