TRANSPORT DROP MAY WARN OF PROBLEMS FOR THE DOW -- A HISTORICAL LOOK AT DOW THEORY
THE DOW TRANSPORTS ARE SHOWING NEGATIVE DIVERGENCE ... One of the more notable patches of weakness over the last week was the transportation stocks. On the week, the Dow Transports fell more than 4% and were by far the market's weakest group. At the same time, the Dow Industrials dropped less than one percent. The fact that the transportation index closed at a three-month low and below its 200-day moving average is a more serious sign of weakness in that economically-sensitive group. That begs a larger question, however. Does transportation weakness portend weakness for the Dow Industrials? That brings us to the Dow Theory which is one of the oldest studies in technical analysis (having been invented by Charles Dow at the start of the 20th century). The Dow Theory holds that in a bull market, industrial and transportation stocks should continue to rise in tandem. The reasoning was that the two were inseparable, since industrial companies made the products, while transportation companies moved them. Weakness in one group usually portended weakness in the other. Which brings us to a comparison of the two Dow averages in Chart 1. The daily bars show the Dow Industrials having recently reached a record high. By contrast, the Dow Transports (solid line) failed to exceed their spring highs and are now falling. The chart shows a clear "negative divergence" between the two. Does that mean anything?
Chart 1
DOW DIVERGENCES PRECEDED 2000 AND 1990 TOPS... Chart 2 compares the two Dow averages over the last ten years. The first thing that stands out is that they generally trend in the same direction. Bull markets in the industrials are usually associated with bull markets in the transports. For example, both bottomed together at the start of 2003 and continued rising together -- until this year. Notice, however, that the transports peaked near the middle of 1999 which preceded the industrial peak at the start of 2000. That's not the first time the transports peaked first. Chart 3 shows that the mid-1990 high in the Dow Industrials was unconfirmed by the transports which peaked the previous October. The result of that negative Dow Theory divergence was a bear market in the industrials in which it lost 20% of its value. Once again, however, both bottomed together at the end of that year and embarked on new bull markets.
Chart 2
Chart 3
DOW AVERAGES PEAKED TOGETHER IN 1994 AND 1987... The transports don't always peak before the industrials. The two Dow averages often peak together. Charts 4 and 5 show that being the case in 1994 and 1987. In both downturns, the two Dow averages peaked together. During 1994, the transports suffered a bear market while the industrials traded sideways for most of that year in what has been called a "stealth" bear market. During 1987, their charts are almost identical and shows them peaking and troughing together. What conclusions can we draw from the last four market downturns? In all four instances, the industrials and transports bottomed together. Having experienced a four-year bull market, however, our concern here is with a possible market top. In two recent tops (2000 and 1990), the transports peaked at least half a year before the industrials. At two other tops (1994 and 1987), the two peaked together. In all cases, however, a drop in the transports either coincided with -- or preceded -- a top in the industrials. That being the case, the recent downturn in the transports should be enough to raise some concerns about the continuing uptrend in the industrials.
Chart 4
Chart 5
