Is Charles Dow Sending us a Warning?

The Dow Theory, developed at the turn of the 20th century by Charles Dow is used by market analysts to determine the long term direction of the stock market. In fact, some use it as a market timing indicator as its performance has been better than a buy and hold strategy over time.  Simply put the Dow Theory states that for the markets to be in an uptrend or downtrend, both indexes — Industrials (DJIA) and transports (DJT) — must confirm each other. This means that when one of index make a new high (or falls to a new low), the other should soon follow. If this does not occur you have what is called a non-confirmation. As a side note and in case you are wondering there is no clear definition of what time period “soon” is.

Right now we have the DJIA making all-time new highs and the DJT has not confirmed by making its own new highs. In fact, as you can see in my chart below, the transports (in the upper pane) have been diverging and moving lower since the end of February when the DJIA (lower pane) made a new high. Adding to that, the fact the DJT just recently broke down below an important major level of support (bottom red line) and continues to lose strength is disconcerting.

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When a non-confirmation occurs, as we have right now, there are two possible outcomes: the first is the index that has not confirmed will eventually do so and by default, confirm the direction of the trend. The second outcome is the leading index changes course and eventually confirms the lagging index thereby signaling a change in direction/trend. Because the requirements for a proper Dow Theory (buy or sell) signal have not been met, combined with the divergence in the two indexes suggests a more cautionary market stance is appropriate course of action right now.