DOW THEORY UPDATE -- DOW TRANSPORTS FAIL TO CONFIRM LAST UPMOVE IN DOW INDUSTRIALS -- DOW THEORY OVERLAPS WITH ELLIOTT WAVES -- MAJOR DOWNSIDE OBJECTIVES WERE COMPLETED IN MARCH -- THE KEY NOW LIES WITH THE S&P 500 EXCEEDING ITS JANUARY HIGH

JANUARY HIGHS ARE THE KEY ... One of our readers asked for an update on Dow Theory. For those of you not familiar with it, Dow Theory requires that the Dow Industrials and Transports must both exceed a previous peak to signal that a "confirmed" uptrend exists. The key to the theory is that the upside breakout has to take place in both indexes. An upside breakout by one isn't sufficient. So far, neither Dow average has exceeded the January high which is required for a confirmed bull trend to exist. Over the shorter term, a slight negative divergence exists between the two. Chart 1 shows the Dow Industrials trading above their 200-day moving average and their May peak. Chart 2, however, shows the Dow Transports stalling at both of those chart barriers. That's in keeping with some other short-term negative divergences that we've written about recently. So far, the negative divergence isn't that serious. But until the Dow Transports close above their May high at 3458 and their 200-day average, the latest upmove in the Dow Industials is "unconfirmed".

Chart 1

Chart 2

DOW THEORY DOWNSIDE TARGETS ... The same reader also asked about Elliott Wave Theory. Back on March 13, I wrote a Market Message entitled: "The Dow Theory Overlaps with Elliott Wave". I explained that both theories required three major downlegs for a bear market to be complete. Let's deal with Dow Theory first. One of the ways to determine a major Dow Theory downside target is to triple the size of the first downleg which lasted from October 2007 to March 2008. Charts 3 and 4, which were posted on March 13, show that downside target to be 616 for the S&P 500 and 6506 for the Dow Industrials. Although the S&P 500 came within 60 points of its major downside target, the Dow hit its target of 6506 in March. I pointed out that the S&P 500 had also come within 6 points of a 62% Fibonacci retracement target at 660 measured from 1982 to 2007 which was is based on Elliott Wave Analysis. With major downside targets having been achieved and bullish divergences apparent in several technical indicators, I took the view that an important bottom was at hand.

Chart 3

Chart 4

WHICH ELLIOTT WAVE BOTTOM?... Charts 5 was posted on March 13 to show two alternate Elliott Wave Counts. The wave count in the top chart suggested that a rally off the March low was only a fourth wave correction in an ongoing bear market (a bear market rally). The wave count in the lower chart suggested that Wave 5 had been completed and that the bear market was over. Both views allowed for a rally to the top of Wave 4 (the January high). What happened from there would determine which of the two views was correct. A close over the January top (Wave 4) would support the view that the bear market is over (which I favor). Several market indexes (the Nasdaq and the NYSE) have already exceeded their January peak. The S&P 500 is still testing that barrier, while the Dow has yet to reach it. An upside breakout by the S&P 500 would support the bullish view based on Elliott Wave. Upside breakouts by the Dow Industrials and Transports would also fulfill Dow Theory requirements.

Chart 5

NYSE ADVANCE DECLINE LINE HAS BROKEN OUT ... Chart 6 shows the S&P 500 still struggling with its January high. It has yet to achieve a convincing upside breakout. Even if it doesn't, a pullback from current levels could still be interpreted as part of a bottoming process (possibly of the head and shoulders variety). One of the reasons I've turned more bullish is the strong action by the NYSE Advance-Decline (solid) line which has already reached a nine-month high (as have many of the other breadth indicators that I've shown recently like the NYSE Bullish Percent Index and the % NYSE stocks over 200 day moving averages). Those indicators suggest this is more than a bear market rally and that a major bottom is in place. What's still in doubt is the shape that bottoming pattern will take. The position of the moving average lines in Chart 6 is also worth noting. Although the S&P has exceeded its (red) 200-day average, the line is still falling. A true bull market requires the 200-day line to turn up. A second bull market requirement is for the (blue) 50-day average to exceed the 200-day line. That hasn't happened yet either. Neither has the S&P cleared its 200-day exponential moving average as shown in Chart 7. The 200 day EMA is more sensitive than the simple 200-day MA which accounts for its flatter slope (it's quicker to pick up recent price gains). A decisive close over that resistance line would be another positive sign.

Chart 6

Chart 7

FIFTH WAVE ADVANCE? ... A case can be made that the rally off the March low has broken down into five waves as depicted in the Nasdaq Composite Index in Chart 8. If that's the case, there's good and bad news related to that. The bad news is that a five-wave advance is usually followed by corrective action (at least back to the bottom of wave 4). The good news is that a five-wave rally implies that the spring rally is the start of a larger uptrend (corrective waves take place in three waves). The question in my mind is whether the spring rally has run its course and some profit-taking in store. That would explain several short-term negative divergences on the last move to new highs like the one shown in the 14-day RSI (red line). Fifth wave divergences are usually more trustworthy.

Chart 8