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Bullish Current Market View Versus Dow Theory Warnings

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I discussed last week in my last Trader's Corner column how, technically, the major indexes (including the Russell 2000) could be viewed as having price objectives above and well above even, prior highs. This analysis was based on a type of 'measured move' objective that suggests that a second leg up will often at least match a first spurt higher. This pattern fits the picture of a 'bull flag' where a first sharp run up (9/18-9/19) is followed by a narrow backing filling movement near the high end of that first advance. When prices rally again to above the top end of such a narrow price consolidation (the 'flag'), a next price objective measured from such a 'breakout' point often suggests that a next move will carry (from that point) as far as the first upswing. Measure out this distance and it becomes a possible 'minimum' next objective.

This measuring technique for bull flag patterns is how I arrived at possible (minimum) upside objectives to 2128 in the Nasdaq 100 (NDX), around 14300 in the Dow 30 (INDU), up to possibly 744 in the S&P 100 (OEX), to 1580 in the S&P 500 (SPX) and even a move back to the area of the 856 previous (summer) high in the Russell (RUT). I don't want to repeat the rationale and marked up charts I used, when anyone interested in back-tracking to this article can see my Wed., 9/26 Trader's Corner ("Waving a Flag") on the Option Investor website by clicking here.

Prices have broken out to new closing highs in the case of the Dow, the S&P 100, the Nasdaq Composite and Nas 100. Well, the Dow as of today hasn't stayed above it's prior 14000 prior high close, but all the major indices are consolidating just under, at, or just over their previous highs from July, which is bullish technical action, suggesting the market has still further upside potential. Maybe my targets will be hit all around. That is, besides the Nasdaq 100 (NDX), given the NDX high to date of 2121 and quite close to my idealized 2128 objective.

DOW THEORY

How can this picture we're seeing near term, suggest anything but a good economy and good market for the next few months? Technical analysis is good only for the near to intermediate-term outlook, right? Possibly WRONG! if we look at the market through the analysis of Charles Dow and his so-call 'Dow Theory'; Charles Dow never called his observations a 'theory'.

The fact that currently the Dow Transportation Average (TRAN) is lagging so much relative to the Dow 30 (INDU) and will be unlikely to ever 'confirm' a new weekly high close in INDU suggests that all may not be so rosy in the economy looking out over the coming 12-15 months.

MORE on Dow Theory shortly; doesn't any bearish concern here conflict with new highs in the Dow, since the market is supposed to be such a good 'discounting mechanism' in pointing to what lies ahead for the economy and future stock performance?

THE MARKET AS A DISCOUNTING MECHANISM

I saw an analyst on CNBC the other night speaking to this topic. He cited an economist at one of my prior corporate masters, Merrill Lynch, on his study of instances when the market was hitting new highs at about the same time the economy was going into, or about to go into, a recession.

The S&P 500 peaked on July 16, 1990 after a 3.4 percent rally over the prior month; a recession began that very same month. Going back to February 13, 1980 points out another instance. This when the market peaked after a huge 7.8% run up in the previous month. The fly in the ointment was that a recession was later judged to have begun the month before.

Could this be a warning to not get complacent on our investment outlook? We do know that some 90% of the economic data has come in below expectations in the past few weeks and some internal market studies, besides Dow Theory, are hitting low-water marks for the year.

Stock markets are not always perfect discounting mechanisms!

CHARLES DOW'S PERSPECTIVE

This foregoing discussion is by way of prefacing that there could be some trouble ahead that stocks have NOT discounted yet. I found this interesting and relevant to what I'm seeing with the lagging Dow Transportation (TRAN) Average. Since I worked at Dow Jones and wrote about Charles Dow there and in my book (Essential Technical Analysis), I will share briefly what the two respective Dow Averages might be telling us at this juncture; and, what Charles Dow's rationale on this subject was about.

Charles Dow, in his observations about the stock market made more than a hundred years ago, was that the transportations stocks, as reflected in his 20-stock average (TRAN), should mirror the 30 stock Dow Industrials (INDU) in making new weekly high or weekly low closes. (Dow didn't concern himself with highs made during the day or week, similar to the way that Candlestick charting considers intraday lows and highs merely 'shadows'.)

Dow observed that if the Industrial Average made a new closing high, it should be 'confirmed' by a new high close in the transports at some point ahead. He observed that if industrial output was good, the earnings trend would also look favorable to investors.

However, if goods start being shipped at a diminished rate, this slowdown will be reflected in declining transportation stock earnings and stock trends; in such a situation TRAN would not 'confirm' new highs in INDU, which is a 'divergence'. Such a non-confirmation can suggest an economic slowdown to come. Lower quarter-to-quarter growth over a certain number of quarters is what defines a recession. What we see on the diverging trends in the Dow 30 (INDU) and the Transports (TRAN) as seen in their weekly line (close-only) charts below, could be an early warning.

You can see that back in July, both Averages went to new highs, thereby 'confirming' the bull market trend. With this latest new high in INDU, there appears to be little prospect of a similar new closing high in TRAN. Not that a new high in TRAN has to occur in a close time frame. But the transports are quite far under the Industrials prior high.

TRAN also looks poised to fall below its long-term up trendline. This trendline aspect by the way is NOT something that Dow would have talked about. However, I take a close below such a long standing bullish up trendline as very significant in defining the point at which a long-term uptrend LOSES upside momentum.

GOING BACK:
LAST DOW AVERAGE NON-CONFIRMATION

The last Dow Theory non-confirmation back in early-2003 was a telling example of how divergences in the two Dow Averages can signal a major shift in the dominant trend; in this case, the shift from a bear market trend to a bull trend.

GOOD TRADING SUCCESS!

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