Tuesday, February 28, 2012

"Dow Theory Divergences" (DIA; IYT)

We posted on this a week ago in "Things that Make You Say Hmmm..."Dow Transports Diverge From Industrials" (IYT; XTN)", here's more.
From Slope of Hope:
...Lastly today I wanted to spend some time looking at the current Dow Theory divergence between the Dow and Transports indices. For those of you who aren't familiar with Dow Theory (DT) I'll recap it very quickly by saying that it is one of the oldest schools of TA, that it has been working well for over a century since being first developed by Charles Dow, one of the founders of the Wall Street Journal, and creator of the eponymous Dow Index. The theory behind it is essentially that in a strong uptrend or downtrend both indices need to confirm new highs or lows, and that when one index makes a new high or low that is not confirmed by the other, then it is a signal that a significant top or bottom may be close.

Here's the weekly Dow vs Transports chart over the last 15 years to illustrate that DT divergences are generally seen at most major highs and lows on the monthly chart, with March 2009 being a notable exception. The current divergence is very striking, with Dow over the 2011 highs and Transports still well below:

Looking at these indices on the one year daily chart, you can see that these indices generally track each other well. There was a new high on Transports in July 2011 that was not confirmed by the Dow and that preceded the waterfall last summer. There was no divergence at the October low, though these divergences do appear more reliably at highs than at lows. The current divergence is very striking, and comparable to that seen at the 2000 and 2007 highs.

What's worth bearing in mind however is that this DT divergence would be eliminated as soon as Transports beat the 2011 high, and that significant previous divergences in 2004 and 2010 lasted for months before confirmation. The divergence in 2004 lasted about six months before Dow confirmed with a new high at the end of that year. It is interesting though, and worth keeping an eye on. If SPX should fall below 1292 I would start paying this signal much more attention: