by Tyler Craig | July 16, 2013 12:22 pm
With the recent ascent of the Dow Jones Industrial Average to yet another all-time closing high that failed to be corroborated by a new high in the Dow Jones Transportation Average, talk of Dow Theory and the notion of confirmation is making the usual rounds.
For those otherwise unfamiliar with these topics, here’s a brief refresher:
Much of our modern-day understanding of technical analysis spawned from the century-old ruminations of an insightful old chap named Charles Dow. His musings on stock market behavior would later give rise to Dow Theory, which is the foundation upon which many of today’s technical analysis tenets rest.
To more accurately assess the overall market trend, as well as have a barometer of business trends, Dow created both the Dow Jones Industrial Average and the Dow Jones Transportation Average. Though the composition of both averages has evolved since the early 1900s, their popularity — and usefulness — has not faded.
In explaining the principle of confirmation, Dow posited that a new high or low in either the DJIA or Dow Jones Transportation Average should be confirmed by a new high or low in the other index. The underlying logic of this principle is deftly articulated in Martin Pring’s book Technical Analysis Explained:
“The need for confirming action by both averages would seem fundamentally logical, because if the market is truly a barometer of future business conditions, investors should be bidding up the prices both of companies that produce goods and of companies that transport them in an expanding economy. It is not possible to have a healthy economy in which goods are being manufactured but not sold (that is, shipped to market).”
If we assess an overlay of both averages year-to-date, it becomes apparent that while the DJIA has risen to a new high, the transports have yet to break back above their mid-May resistance level (see falling red trendline).
So what should traders make of the inability of transports to follow in the footsteps of the industrials? Is this an ominous sign portending imminent doom for an overheated stock market?
Far from it.
Bear in mind that these two averages don’t mimic each other with precision. One often lags the other and requires additional time before confirmation is finally delivered. Case in point, the transports originally broke out to a new all-time high early this year (Jan. 15), and it wasn’t until almost four months later (May 5) when the industrials finally followed suit with a new high.
Besides, there are plenty of other indices that have ascended to new heights alongside the DJIA this week, including the Nasdaq and Russell 2000 — both of which are very broad indices in their own right. I suspect the Transportation Average will join the new-high club shortly.
Indeed, it seems inevitable if the aging bull market continues its relentless rise.
If you’re looking for bullish exposure to transports, Union Pacific (UNP) boasts a pretty compelling chart. UNP has formed a nice little two-month base and appears poised for a breakout that could kick start its next up-leg.
Earnings loom just around the corner, though — before the bell Thursday — so the risk of an outsized gap is elevated.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.
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