Dow Theory Divergences

I’ll be doing a post next weekend on the effect that QE has had in the past on equities (up), bonds (down) and commodities (up). As I’m expecting equities to retrace over the next week though I thought I would talk this week about the current Dow Theory divergences and why these are worth keeping an eye on.

Dow Theory is one of the oldest of the technical analysis schools, and was derived after his death in 1902 from 255 editorials written on the Wall Street Journal by Charles Dow. Dow Theory watches divergences between two Dow indices which are the main Dow Industrials index (Dow) and the Dow Transports (Tran) index. The theory in essence regards the Dow as representative of equities and the Tran as representative of the real economy. Divergences between the two are signals that change is in the air and that a major reversal may be coming. These divergences can persist for a while though before that happens.

On the chart below there are two divergences, long and short term. The longer term divergence is that the Tran made new all time highs in 2011 that have not yet been confirmed by the Dow also making a new all time high. Dow is within striking distance of making an all time high however, and if we see the usual QE-fueled bull run happen, then that divergence may well disappear soon.

The shorter term divergence is that Tran has seriously underperformed Dow since that 2011 high, and at the close today was 9% below the 2012 high, and almost 13% below the 2011 high. Tran has failed to confirm the new high on Dow over the April 2012 high. The divergence has grown very wide this week as Dow has traded sideways and Tran has been hammered by downgrades of major Tran component companies due to weak sales and profits there:

In the short term Tran broke down from a large symmetrical triangle and closed below a three month trading range on Friday. Having already given back 80% of the gains from the June lows, a test of those June lows on Tran now looks close and likely. With Dow at new highs for 2012 and up almost 13% since the June low the contrast between the two is stark. This reflects the divergence between the real economy, weak and very possibly going into recession, and equities, actively being supported by a Fed determined to increase asset prices in the hope that will also ultimately boost the economy. Here is the very bearish looking Tran daily chart showing Friday’s breakdown:

Does that divergence between equities and the economy still matter in this environment? I don’t believe there has been a period before in the history of Dow Theory where the government / Fed was nakedly supporting equities in the teeth of a deteriorating economy, and it may be that this current divergence is signalling an equities high that the Fed can and will prevent, or at least delay, from happening. That equities high in the absence of QE3 may well have been signaled by the huge bearish topping patterns across many indices and commodities that have formed over the last two years but have been breaking up over the last month in the face of QE3.

From a technical standpoint, ignoring the very bearish look of the Dow Theory charts, at least some more upside on equities during QE3 looks likely. As QE hasn’t had much noticeable effect on the real economy in the past, that will stretch the divergence between the real economy and equities further while equity buyers suspend their disbelief in the face of QE3, and we will see how far that can go before the markets revert to the mean.

From a fundamental standpoint, sustained and increasing divergences between bullish equities and a weaker real economy have a name, and that name is speculative bubble. These aren’t usually deliberately created by the Fed, though the last two in 1996-2000 and 2003-7 were certainly helped along by overly loose Fed policies. Bubbles tend to take markets to high valuations and burst with very steep declines, as we saw in 2000-2 and 2007-9. The tops of the last two bubbles were very well signaled with topping patterns on SPX and hopefully this will be the case here too. When those topping patterns appear it will be time to exit swiftly.

Short term more retracement looks likely but that was only to be expected in any case. At the start of QE2 there was a run up on equities in anticipation of the heavily trailed QE2 announcement, a spike into overbought RSI territory and over the daily bollinger bands on the QE2 announcement, and then a deep retracement over the next three weeks before the main QE2 bull run up got started. So far SPX is following the same script as you can see from the chart below with the QE2 period highlighted in blue:

The Tran chart is a warning here that the retracement over the next week or two may go further than expected. Many analysts are expecting the 1435-40 area on SPX to hold, and there are major support levels underneath at 1415-20 and 1395-1400. The post QE2 retracement on SPX retraced all the way to test the lower bollinger band on the SPX daily chart. That was at 1380 at the close on Friday and I’d expect that to be in the 1395-1400 area in a week or so. That may well be the target for this retracement as well.

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