One of the basic, if often questioned, tenets of Dow Theory is confirmation or nonconfirmation. This very strong indicator holds that a major market turn must be signaled by both the Dow Jones Industrial Average and the Dow Jones Transportation Average. In the last few weeks, we seem to have been developing a pattern that Charles Dow would have called a nonconfirmation.
To understand the principle, we first have to recognize the waves that make up market motion. Dow categorized primary moves as the large market moves lasting a year or more that we are now in the habit of calling bull or bear markets. Within that, he looked at the smaller moves, usually lasting three weeks to three months, and called them secondary moves.
On the two charts below, one of the industrials and the other of the transports, we see the big upward move in both indices that started in early 2003. That would be called a primary move. Within that advance there have been a number of shorter-term ups and downs lasting weeks or months, which would be classified as secondary moves.
First let's look at the lows in late 2002 and early 2003, marked by blue circles. After a long decline off the market highs in 2000, both indices made a series of lows. But notice that the industrials did not go as low in March 2003 as they had in October 2002.
On the other hand, the transports did make a new low. This constituted a disagreement, a nonconfirmation, which suggested the decline might be coming to an end. When they later both went higher than the prior high, the upturn was legitimized. So a classic Dow nonconfirmation signaled the turn of the primary trend to the upside.
Now let's look at the recent action. In both cases we had a new high made in May and a secondary wave to the downside thereafter. But now the Dow industrials have gone to a new high while the transports are lingering well below the March high. This has the look of a nonconfirmation. Of course, the transports could still rally enough to confirm the industrials, so it's not a firm signal yet.
If, on the other hand, the indices start to make a secondary down move with the transports not confirming the industrials, we would have a definite Dow Theory sell. The next few days or weeks will tell the story. At this time, we have a potential Dow Theory sell signal that looks very worrisome.
P.S. Will you be there when Cramer makes his next move?
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At time of publication, Arms had no positions in the stocks mentioned.Richard Arms is a renowned stock market technician who invented the Arms Index (often referred to as the TRIN), which has become a mainstay of market analysis, appearing in The Wall Street Journal and Barron's. Arms also developed the widely used technical method Equivolume Charting. Since 1996, he has been publishing the Arms Advisory newsletter for money managers and financial institutions. He also has authored Profits in Volume, Volume Cycles in the Stock Market, Trading Without Fear and The Arms Index, and has been honored with the Market Technicians' Award for Lifetime Contribution to Technical Analysis. At the time of publication, he had no positions in stocks mentioned in this report, although holdings can change at any time. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. Richard appreciates your feedback; click here to send him an email. TheStreet.com has a revenue-sharing relationship with Trader's Library under which it receives a portion of the revenue from purchases by customers directed there from TheStreet.com.
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