Dow Theory: Party While It Lasts

Includes: DIA, IYT, NYC, SPY
by: New Low Observer

Dow Theory is all about confirmations. What happens in one index should occur for the other index. Without confirmation, the theory says, then all bets are off in terms of the preceding direction of the index. Yesterday's action in the Dow Industrials was impressive, with the index hitting a brand new high since the March 9, 2009 low. Not to be outdone, the Transports were in a mood to go to new highs as well. As a critic of the markets and one who practices Dow Theory, I feel that the new highs are not completely to my liking.

First, let's review a little about what Dow Theory has done for us lately. From a literal and practical perspective, Dow Theory has definitely pointed the way to the increase in the market since June 23rd and possibly since my March 20, 2009 posting. So far, the March 20th article has been 100% accurate about the direction and extent of this market move upward. It is worth rereading that article to glean the nuances about Dow Theory that is seldom found anywhere else. However, attention to the details of the changes in the Transports and Industrials on March 9th made it possible for me to feel confident about my research recommendation of March 10th.

Additionally, Dow Theory served its purpose quite well when, on November 12, 2007 in Barron's, Richard Russell was explicit in his interpretation of Dow's Theory calling for a vicious bear market. A greater piece on the instructions to get out of stocks hasn't been written since WSJ editor William Peter Hamilton's "Turn of the Tide" call of the market peak of October 25, 1929 (using Dow Theory, of course.)

The chart below is a continuation of the chart that I posted on September 2, 2009. In that article, I expressed the view that future market movement was clearly being transmitted in the Transportation Index. At the time, it was clear that the Transports were exhibiting double tops and double bottoms as a means to provide support and resistance levels. Each test of double bottoms were easily resolved by the Transports moving above prior double tops.

As we now know, every new high in the Industrials, since the March 9th low, has been grudgingly accompanied by new highs in the Transportation index. This is powerful stuff since the Transports have acted as the proving ground for any moves upward. Basically, we've needed the Transports to co-sign on the Industrials claims that this is a bull market. Up to this point, the Industrials have had their checks cashed. However, the current market moves hasn't had the full endorsement of the Transports based on the November 4, 2008 peak.

On September 11, 2009, I spoke at length about that fact that the Transports couldn't seem to go above the November 4th peak. Although both indexes have gone to new highs, the Transports have been able to close above 4,071.81. Without this barrier being crossed resoundingly, the bull market will be on hold. The chart below shows how close we are to a true confirmation of a continuation in the cyclical bull market trend within a secular bear market.

Note that the volume in the Transports has been in a declining trend since March. This is in stark contrast to the volume on the Industrials, NYSE, and S&P 500 which has been relatively flat since mid-June. The declining volume in the Transports tells us to party while we can because when the music stops there'll be a big mess to clean up afterwards (a major retest of old lows.)

While most might be focused on the Dow Industrials or S&P 500, the Transports tell us what we need to know. Despite the fact that confirmation of this index is likely, even though the economic conditions don't seem to match the markets outlook, we should continue to watch closely for any signs of capitulation.

Disclosure: No positions in indexes