The Dow Report: A Look at Dow Theory Confirmations
By Tim W Wood CPA, September 5, 2003
This is the first of a series that will now appear regularly with Financial Sense Online. In this report I will discuss Dow theory as it relates to current market conditions. I will also use this series to introduce various Dow theory topics and tools that have been used by the great Dow theorists from the past.
The first item that I want to discuss today is one of the most commonly thought of elements of Dow theory; that being, the subject of confirmation and non-confirmation. In looking at Dow theory principles we use closing price only and for this principle we compare the price action of the Dow Jones Industrial Average with the price action of the Dow Jones Transportation Average. If both averages move up or (down) together and thereby both averages move above or (below) the previous high or (low), we then have the averages in agreement and thus they are confirming each other. This is known as being “in gear.” If both averages fail to confirm one another, then we have a non-confirmation. In this case the averages are not “in gear.” When a non-confirmation occurs in a downtrend it should be taken as a warning that a bottom could be forming and thus the trend could be changing. If the market is trending up a non-confirmation should be taken as a bearish sign that the market could be topping and that the trend could be trying to reverse to the downside. My studies show that major turning points such as seasonal and 4-year cycle tops and bottoms tend to occur with these non-confirmations. However, I must also point out that not all market turns occur with the formation of these non-confirmations.
A Lesson from the Past
In order to illustrate this principle, I have selected a time period that we should all remember, that being, August through December of 1987. Notice on the chart below that at the first minor top, within the larger August top, which occurred on August 17, 1987 at 2,700.57 on the Industrials was confirmed by the Transports the day before at 1,101.16.
From this point the market rolled over into a minor low on August 18, 1987. From this low the market rallied again. However, this time the Industrials move above the previous high while the Transports lagged. On August 26, 1987 the market turned back down and because of the lagging Transports a classic Dow theory non-confirmation was born. This non-confirmation is labeled point “A” on the chart above.
The next point I want to illustrate is the confirmation of the downside move. This occurred at point “B.” Note that both averages moved into the early September low. This occurred on September 8, 1987 at 2,545.12 on the Industrials and 1,012.12 on the Transports. From there a small rally developed. This rally turned down 5 days later and on September 16th the Industrials moved below the September 8th low. This was then confirmed by the Transports on September 21st when the Transports moved below their September 8th low to close at 1,005.80. According to the great Dow theorists of the past a break of only one tick is enough to serve as confirmation or non-confirmation. This break may be hard to see on the charts but it was a break of some 7 points so it did indeed serve as downside confirmation. From this point the market rallied into the October 2nd high only to plunge into the October 19, 1987 closing low at 1,738.74 on the Industrials. The following day the Transports closed at 740.25. From the October lows the market began to rally once again into a minor top on October 21, 1987. From this minor top the market fell again into the October 26, 1987 low, which occurred at 1,793.93 on the Industrials and 674.92 on the Transports. This in turn setup a small bullish non-confirmation because the Transports had fallen below the October 20th low while the Industrials held above their October 19th low. This was the first positive sign that the market was trying to bottom. From the October 26th low the market then rallies into November 2nd. Note that this rally failed to carry either average above the October 21st rally high. Therefore, no confirmation of the up trend was given. From the November 2nd top the market once again drifted lower. This time, into a low on December 4, 1987 at 1,766.74 on the Industrials and at 661 on the Transports. This setup a larger non-confirmation because the Industrials held above the October 19th low while the Transports violated their October 20th low. This non-confirmation did indeed prove to mark the low for the crash of 1987. As the market moved up into January and February of 1988 the bullish move was confirmed once the previous October and November highs were bettered to the upside.
The Current Situation
In reviewing the chart below you can see that there was a Dow theory non-confirmation at the March 2002 low. This was a warning that proved to be very real. I have marked this non-confirmation on the charts below with trend line “A.” From the March low both averages moved up “in gear” until June 12, 2003. At this point the Transports had failed to confirm the stronger action of the Industrials. This is marked by the vertical line labeled “B.” Then on July 9, 2003 the Transports move into new high ground but this time the Industrials were lagging and therefore a non-confirmation still existed. This non-confirmation is marked with the vertical line labeled “C.” On August 18, 2003 this non-confirmation was corrected as both averages moved above all recent high points since the March rally began. This is marked by the vertical line labeled “C.” Therefore, as it stands today both averages are confirming the move up from the March 2003 low and until this changes it is indeed a positive sign for the market.
The Current Week in Review
The Dow Jones Industrial Average closed the week at 9,305.34, up 87.52 points for a weekly gain of .929. The Dow Jones Transportation Average was also up 64.05 points closing the week at 2,747.29 for a gain of 2.39 for the week. The move into the recent highs were confirmed by both averages. The S&P 500 closed at 1,021.37, up 13.67 points for weekly gain of 1.36%. The week and the NASDAQ composite was up 47.65 points closing the week at 1,858.10 for a weekly gain of 2.63%.
My work also shows a trading cycle low that is coming due in mid to late September. We should now be moving into this low. The decline into this low and the rally that follows will be the next opportunity for any non-confirmation to occur. We must now simply monitor the price behavior as we move into and out of this trading cycle low. Should a non-confirmation occur at this time it could spell trouble for the market as we are now due a move into the seasonal cycle low. By the same token, as long as the averages continue to confirm each other on the upside, all remains positive from this perspective.
Tim W. Wood
© 2003 Tim Wood