Dow Transports lagging is a warning sign

There are still a lot of Dow Theory followers out there even after over 100 years. And the divergence between a bullish DJIA headline number and the lagging Dow Transports is bearish from a technical perspective.

Here’s how Wikipedia describes the Dow Theory:

The Dow theory on stock price movement is a form of technical analysis that includes some aspects of sector rotation. The theory was derived from 255 Wall Street Journal editorials written by Charles H. Dow (1851–1902), journalist, founder and first editor of the Wall Street Journal and co-founder of Dow Jones and Company. Following Dow’s death, William Peter Hamilton, Robert Rhea and E. George Schaefer organized and collectively represented Dow theory, based on Dow’s editorials. Dow himself never used the term Dow theory nor presented it as a trading system.

The theory is all about internal technicals of the market. The thinking is this: A market has three trends – a primary trend and medium and short swings. These three trends breakout or breakdown based upon technical signals that show divergence in key sub indices like the Dow transports. When a trend breaks out there is a subindex divergence to the upside. When the trend breaks down, the sub index is lagging to the downside.

Bottom line: for the trend to continue, you need to see heady volume and you need the indices to confirm each other and they are not doing that right now.

This past Friday, the Dow Jones Industrial Average broke above its April 2011 high. Very nice. But the transports have been breaking down. Here’s my read of what is happening: the market is hitting new highs because earnings growth remains in place albeit at a moderating pace. Meanwhile, trade indicators are coming up short, confirming the global growth slowdown. If you follow things like the Baltic Dry Index, you’d know that it too is breaking down. It ended a 33-day losing streak just today. Net Dry bulk pricing has gone negative because overall shipping costs are at record lows. On the other hand, US rail traffic is still doing moderately well.

For the up trend to continue, we will need to see the Dow Transports re-assert themselves. otherwise, their breaking down is a foreshadowing of a market correction.