Dow Theory Divergences

Dow Theory Divergences

Courtesy of Springheel Jack

Dow Theory divergences are worth keeping an eye on. The theory was postulated by Charles Dow and elaborated on after his death in 1902. It is based on 255 editorials Mr. Dow had written in the Wall Street Journal.

Dow Theorists monitor divergences between two Dow indices: the main Dow Industrials index (DOW) and the Dow Transports (TRAN) index. DOW represents equities, while TRAN is considered to mirror the real economy. Divergences between the two are signals that a major reversal is coming, however, these divergences may persist for a while before the reversal ensues.

On the chart below, there are two divergences, long and short term. During the longer term divergence, TRAN hit new all time highs in 2011 that have not been confirmed by the DOW making new highs. DOW is now within striking distance of making an all time high however, and if we see the usual QE-fueled bull run up, then that divergence may soon disappear.

The shorter term divergence shows that TRAN has seriously underperformed DOW since the 2011 high. At the close on Friday, TRAN was 9% below its 2012 high, and almost 13% below its 2011 high. TRAN has failed to confirm the new high on DOW over the April 2012 high. The divergence grew very wide this week as DOW has traded sideways while TRAN was hammered by downgrades of major TRAN component companies due to weak sales and profits.

[click on charts to enlarge]

 

TRAN broke down from a large symmetrical triangle and closed below a three month trading range on Friday. Having already given back 80% of the gains from the June lows, a test of June’s lows looks likely.

With DOW at new highs for 2012, up almost 13% since the June low, the contrast between the two is striking. This reflects the divergence between the real economy, which is weak, and equities, which are being actively supported by the Fed. The Fed is determined to increase asset prices in the hope that will ultimately boost the economy and improve a dire unemployment situation.

The TRAN daily chart looks bearish, following Friday’s breakdown:

 

 

Does the divergence between equities and the economy still matter in this Fed-enhanced environment?  There hasn’t been a period in the history of Dow Theory in which the Fed has so blatantly supported equities in the teeth of a deteriorating economy. It may be that this current divergence is not forewarning a reversal because the Fed is working to keep stock prices higher.

QE-3 (or QE-Infinity) may change the usefulness of Dow Theory.

From a technical standpoint, ignoring the Dow Theory prediction for a reversal in stocks, more upside in equities during QE3 looks likely. As QE hasn’t had much noticeable effect on the real economy in the past, that will stretch the divergence between TRAN, reflecting the real economy, and DOW (equities), even further. Only time will tell whether and when a reversion to the mean will occur.

From a fundamental standpoint, sustained and increasing divergences between bullish equities and a weaker real economy have a name, and that name is “speculative bubble.” Speculative bubbles were nurtured by the Fed’s loose polices in 1996-2000 and 2003-2007. Bubbles tend to take markets to high valuations, but they eventually burst and decline in the aftermath. The tops of the last two bubbles were signaled with topping patterns on SPX. Hopefully this will be the case now.

Short term, retracement looks likely. At the start of QE2, there was a run up in equities in anticipation of the QE2 announcement. A deep retracement over the next three weeks followed. SPX may be following the same script. On the chart below, the QE2 period is highlighted in blue:

 

 

The TRAN chart is signaling a retracement. Many analysts are expecting the 1435-40 area on SPX to hold, and there are major support levels at 1415-20 and 1395-1400. I think the 1395 and 1400 area is a reasonable target for near term retracements.

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