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By: Costas Bocelli — October 4, 2012

Will Dow Theory Kill the Rally?

If these were conventional times, the third quarter should have been very tough on the bulls.  But we know that wasn’t the case.  The S&P 500 index finished the quarter with a 5.7% gain, even after shedding nearly 2% in the final two weeks.

And Main Street’s favorite stock market barometer -- the Dow Jones Industrial Average -- closed out the quarter with a 4.3% gain.  Both indices have entered into the final quarter this week within spitting distance of setting another multi-year high that dates back to late 2007.

DJIA (Year to date, ending September 28)...
 

But if you happen to subscribe to the time-tested tenets of Dow Theory, then you have become keenly aware that something is rotten in the state of Denmark!

Below is a similar chart on the Dow Jones Transportation Average, a sister index of the DJIA, which is comprised of 20 economically sensitive components such as airlines, shippers, truckers and railroads.

DJTA (Year to date, ending September 28)...

 
While the Dow has been in rally mode, racking up a 4.3% gain in the third quarter, the Transports on the other hand have slid sharply for a 6.1% loss in the same period.  Clearly there is a big disconnect between the two and, because of this, it’s now flashing a major warning sign that usually sends Dow Theorists and market technicians running to the nearest exit.

If we put these charts together on a relative scale, you can easily visualize the huge divergence that has materialized.

DJIA/DJTA relative strength (Year to date, ending September 28)...

 
The Dow Industrials have outpaced the Dow Transports by roughly 12.5% over the first nine months of this year.  But what is most alarming is that the divergence expanded a staggering 10.5% just in the last three months, creating this graphical distortion that you can drive a truck through.

You see, according to Dow Theory, these two particular indices must confirm each other -- meaning that they should be moving in the same direction -- for the current trend to remain sustainable.

And while the Dow Industrials have been rallying, the Transports have lost their way.

What sets off the warning sign is that the Transports usually lead the Industrials.  Because the index is comprised of large, economically sensitive companies that have vast global footprints on commerce and trade, they tend to be a leading indicator for overall corporate growth and profits.

And lately, they’ve been painting a gloomy picture.  Recent profit warnings and lowered forward guidance from Federal Express (FDX) and Norfolk Southern (NSC) have weighed heavily on the index.  Weakening commodity prices and softening demand for industrial materials like crude oil and iron ore have also played a part in the divergence.

Usually, when this happens, the technical action of the Transports wins out and you see broad markets eventually succumb and follow the path of the Transports.

The last time we saw a significant divergence between the Dow and the Transports in a bull trend was actually earlier this year.

And we discussed it in my March 1, 2012 Tycoon Report article, Dow 13,000: Be Very Careful Here.

If you recall, the Dow was in rally mode from the 2011 summer lows and was toying with the 13,000 level.  But while the Industrials were retracing old 2008 highs, the Transports were selling off, creating the divergence, and sending us a warning signal.

We obviously know what has transpired since, simply by looking back at the historical daily chart.  The Dow peaked out around 13,300 -- less than 2.5% higher -- over the next two months before it finally sold off 1,000 points and found its last major bottom in early June.

The Transports were indeed a reliable indicator that the sustained rally in the Dow was in danger and that most likely some type of correction or headwind of resistance was going to follow.

But what about now? 

The divergence is even more pronounced.  Surely you have to agree that the Transports have been trading awful, especially compared to the Dow Industrials.

Analyzing this information in a vacuum, it looks like the broad markets are going to sell off.  And based on the magnitude of the divergence, the declines could easily be 10% to 13%, which would officially put it in correction territory.

But as I alluded to you in my opening statement, we’re not in a conventional market environment.

This is the new normal, where central bankers have taken it to a whole ‘nother level.  Sub-zero real interest rate policy for years to come and unlimited pledges to buy government bonds ensures the flow of global liquidity and takes Lehman style threats and systemic failure off the table.

That’s the current reality.

And the actions over the past several months have only further inflated risk assets like the industrials while exposing the serious economic problems facing the global economy squarely seen through the dismal performance in the Transports.

If the Transports do not find a bottom soon and close the divergence, the most likely course is an intermediate term pullback and a pause in the current rally.

But until the central bankers are forced to change their aggressive and loose monetary behavior, any pullback should be shallow and provide good opportunities to add to your long term investments.

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