DOW TRANSPORTS AND DOW INDUSTRIALS BREAK SUPPORT -- TREND IDENTIFICATION -- PRIOR DOW THEORY BUY SIGNAL -- CURRENT DOW THEORY STATUS -- LOOKING OUTSIDE DOW THEORY FOR CONFIRMATION -- BREADTH REMAINS WEAK

DOW THEORY REVIEW... Today's Market Message was written by Arthur Hill. John Murphy will be back tomorrow. - Editor

Today I would like to review Dow Theory and look at the current signal. The "Dow Theory" evolved from the writings of Charles Dow at the turn of the century (1900, not 2000!). Dow founded the Wall Street Journal and was editor until 1902. He also created the Dow Jones Transportation Average and the Dow Jones Industrial Average. The Dow Theory was not explicitly laid out by Dow, but rather defined and refined from his writings by William P. Hamilton, Robert Rhea and E. George Schaefer.

The Dow Transports and the Dow Industrials must confirm each other. This is one of the six tenets that emerged from Dow's writings. In a nutshell, a bull market is confirmed when both Averages record a higher high and a bear market is confirmed when both Averages record a lower low. Failure by one Average to confirm the other results in a non-confirmation.

Chart 1

TREND REVERSAL... A Dow Theory sell signal occurs when both Averages reverse their uptrends and start downtrends. There are three steps to a downtrend. First, an initial decline forms a reaction low. Second, the subsequent bounce fails to exceed the prior high and a lower high forms. Third, this lower high is followed by a decline that exceeds the prior low. The basic definition of a downtrend is lower lows and lower highs. It starts with the first lower low after the first lower high. Once a trend starts, it remains in force until proven otherwise. Neither the length nor the duration can be determined ahead of time. This also stems from Dow Theory.

Chart 2

PRIOR BUY SIGNAL... Before moving on to the current Dow Theory signal, let's take a look at the prior bullish confirmation signal from September 2006. Yes, a Dow Theory buy signal was in effect for almost a year. The Dow Industrials got it started with a surge in June, a higher low in July and a break above the prior high in August. The Dow Transports confirmed this breakout a month later. The Dow Transports surged in July, formed a higher low in August and broke the August high in September. The breakout in the Dow Transports confirmed the breakout in the Dow Industrials and a Dow Theory buy signal was in force.

Chart 3

CURRENT CONDITIONS... Now let's look at the current Dow Theory situation. Both the Dow Industrials and Dow Transports surged to new highs in July and this affirmed the current uptrend (bull signal). After this surge, both declined sharply and broke below their June lows in August. According to Dow Theory, a downtrend requires a reaction low, a lower high and a lower low. So far, both formed the first reaction low and we have yet to see a bounce. In other words, according to Dow Theory, it is still too early to call for a downtrend and a Dow Theory sell signal.

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MIXING ART AND SCIENCE... This is the point where judgment comes into play and we have to use the "art" side of technical analysis. Even though it may be premature to call for a downtrend, both Averages clearly broke their June lows and forged lower lows. These lower lows reflect a significant increase in selling pressure and this is bearish. In addition, we can peek outside the box and see what's happening elsewhere in the market. John Murphy pointed out the breakdown in the retailers and the Consumer Discretionary SPDR (XLY) on Tuesday. The Retail HOLDRS (RTH) formed a double top, broke its June low in July and exceeded its March low in August. That looks like a downtrend to me. XLY formed a lower high in July, broke its June low and moved below its March low. These two groups are just as sensitive to the economic cycle as the Dow Transports and recent breakdowns are clearly bearish.

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FINANCE AND BROKERS HELP BEARISH CAUSE... In addition to these breakdowns, we also have clear breakdowns in the Finance SPDR (XLF) and Broker Dealer iShares (IAI) as both moved below their March lows. Even though these two may be oversold and ripe for a bounce, the decline over the last five weeks is more than enough to start a downtrend. Downtrends are typical faster and steeper than uptrends, but we should not expect one big sharp move, although it is certainly possible. More likely, there will be correction rallies and oversold bounces along the way. It is part of the natural ebb and flow of a trend.

Chart 7

BREADTH FURTHER CONFIRMS WEAKNESS... Breadth continues to deteriorate. There are three key breadth indicators that I look at: the AD Line for the NYSE, Net New Highs for the NYSE and Net New Highs for the Nasdaq. The AD Line for the Nasdaq has a long-term negative bias so I do not use it on the regular basis. The chart below shows the Nasdaq AD Line over the last 2 1/2 years. While the Nasdaq advanced over 30% during this timeframe, the AD Line steadily declined with a series of lower lows and lower highs. The discrepancy between the AD Line and the Nasdaq probably lies with the listing requirements and issue quality. The Nasdaq requirements are less stringent that those of the NYSE. It is easier for riskier companies to list on the Nasdaq and stay listed, even if they get into trouble or never make money. The most speculative issues (think upstart biotechs) list on the Nasdaq and many of them go bust.

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NYSE AD LINE TRENDING LOWER... The trend for the NYSE AD Line is clearly down. The NYSE AD Line formed a lower high in July and broke below its prior low with a sharp decline at the end of July. According to Dow Theory, this marks a definitive trend change: sharp decline, lower high and lower low. The AD Line barely bounced with last week's rally and moved to new lows again this week. It looks like the March lows mark the next stop.

Chart 9

NET NEW HIGHS ARE NEGATIVE... Net New Highs for the Nasdaq and the NYSE are also in bear mode. Net New Highs equals new 52-week highs less new 52-week lows. The indicator is positive when there are more 52-week highs and negative when there are more 52-week lows. I use a 10-day SMA of Net New Highs to smooth the data series. 52-week lows do not come easy and we should take notice when 100s of stocks are recording these. The 10-day SMA for Net New Highs moved into negative territory in mid July and broke below -300 this month. For the Nasdaq, the indicator moved into negative territory in July and broke below --250 in August. These are the lowest readings since 2002 and this decline is more than just the garden variety. At the very least, it will take time to undo this technical damage, form a base and reverse course.

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WEIGHING THE EVIDENCE ... The bulk of the evidence is clearly bearish. Given the breakdowns pointed out above, I would consider the recent price action in the Dow Transports and Dow Industrials as bearish. Both clearly broke their June lows with sharp declines and these breaks are backed up by even bigger breaks in the Finance SPDR (XLF), Broker Dealer iShares (IAI), Retail HOLDRS (RTH), Consumer Discretionary SPDR (XLY) and NYSE AD Line. The market is sending out a message and we best abide by its contents.