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Dow Theory Divergence?

The Dow Theory is an investment theory developed by Charles Dow that attempts to find patterns and trends based on market behavior and investor psychology. Dow Theory applies the principle of confirmation to confirm primary trends. Charles Dow utilizes the Dow Industrials and Dow Transports to confirm the primary trend for the broader market. The theory stipulates that the market is strong or in an uptrend (bullish) when the Dow Jones Industrial Average (INDU) and the Dow Jones Transportation Average (TRAN) both advance above their previous highs. For instance, if INDU records a new all-time high, TRAN should also follow suit with a new all-time high.


The concept is the market discounts everything (forward-looking), the market moves in trends, and confirmations. Under such a premise, different market indexes such as INDU and TRAN must confirm each other in terms of price and volume patterns to signal the sustainability of the primary trend. A non-confirmation or divergence occurs when one average falls short and does not confirm the higher-high pattern in the other.


Since the stock market is a proxy for the overall business cycle when Transportation Average (TRAN) is breaking out to the upside along with Industrial Average (INDU), then this is a good sign of a robust economy. After all, the stock market is one of the leading economic indicators. Industrials produced capital goods used in the construction and manufacturing and Transports are involved in the shipments of the goods when both are performing well it bodes well for a bull rally.


Confirmation of primary trends is critical to sustainable trends. A negative divergence between two markets or between two securities also can warn of an impending change in trend.


As you can see from the attached chart, when the Dow Jones Transportation Average and Dow Jones Industrial Average break out, it is generally favorable for the overall stock market. However, when transports or industrials struggle, it tends to signal uncertainties in the economy or political/geopolitical concerns leading to broad market consolidations or selling. But when the consolidation ends and INDU and TRAN then resumes its uptrend, this sends a very bullish message to investors/traders resulting in the next bull trend.


Also, note the current correlation between the Transportation Average and the Industrial average is 0.96. This high correlation suggests both are trading in sympathy with one another. However, a divergence has developed as TRAN has recently set new all-time highs via a higher-high pattern, and INDU has recorded a lower-high. Although INDU can still record new all-time highs and confirm a Dow Theory buy signal, the technical message right now is that there is a non-confirmation, or a Dow Theory sell signal. As mentioned before, one tenet of the Dow Theory is that both averages should confirm their trends to have a healthy bull market.


In summary, TRAN is currently diverging from INDU or a Dow Theory sell signal. If this trend continues, does this warn of the next major correction?


Source: Courtesy of StockCharts.com

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