The growing disparity between the Dow Jones Industrials ($INDU) and the Dow Jones Transports ($TRAN) is symptomatic of a market that is profoundly split. How this divergence is resolved will be an important clue as to whether another bear market is again on the horizon.

Dow Theory has its origins in the writings of Charles Dow -- founder of the Wall Street Journal and creator of the Dow Jones Industrial Average. His Journal editorials pioneered technical analysis. On his death in 1902, William Hamilton continued Dow's work, writing editorials of his own until 1929. Robert Rhea then collected the work of both of these men and used it as a basis to publish The Dow Theory in 1932. This book expounds many key principles of stock market analysis, such as defining the nature of the Primary, Secondary and Minor trends. The concept from this book that I am concerned with at present is -- "The Two Averages Must Confirm."

The two averages in Dow's time were the Industrials and the Rails. The logic was simple: industrial companies manufactured the goods and the rails shipped them. When one average recorded a new Secondary or Intermediate high, the other average was required to do the same in order for the signal to be considered valid. 

If the two averages acted in harmony, with both reaching new highs or lows in relatively the same time period, then the price action of each was said to be confirming. If, however, one average went to a new high, but the other average didn't follow suit, then there was bearish divergence. If the opposite occurred, with one average reaching a new low, but the other holding above a previous bottom, then the divergence was bullish. Robert Rhea then analyzed these new highs or lows in terms of the market's Secondary or Intermediate trend. The time frame of this trend is considered to be at least three weeks and can last three or more months.

At present, of course, the rails are now the Transports. Dow Theorists argue that the principle remains valid. As such, they contend that the activity of the Industrials and Transports provides a filter to detect whether the stock market is in a healthy or unhealthy state.

Weekly charts of the Dow Jones Industrials and Transports are juxtaposed below. I have started both charts near the end of the three-year bear market in July 2002. Each Intermediate peak and valley is assigned the same number so an entire "move" can be easily identified. Note that at point 3, the Industrials made a higher low than at points 1 and 2, but the Transports at 3 made a lower low. This was important bullish Dow Theory divergence and was a signal that a major change in trend was taking place. Shortly afterwards, the bear market in both indices ended with a triple bottom formation. Note the break in a multi-month downtrend line. Also note how prices rose above the 30-week moving average, which began to slope upward (thus beginning the stage II advance I have written about numerous times in recent Swing Trader issues).

Observe also that the downtrend lines were broken very close to the same time in May 2004. Clearly, the two averages were "in gear" with each other. This period of confirmation lasted through point 4 in early January 2004 when both averages hit peaks, as well as through point 5 in April when both recorded lower Intermediate-term highs and lows.

Starting at point 6 in late June 2003, however, the divergence in the two averages can be clearly observed. The Industrials hit a lower Intermediate high than at point 4 or 5 -- the definition of a downtrend. The Transports, however, not only bettered their previous peak at point 5, but also took out the peak of point 4. The activity of both averages at point 7 reinforces the divergence. The Dow Jones Industrials remains in a strong downtrend, whereas the Transports are hitting multi-year highs. The Industrials are below a declining 30-week moving average and the Transports above a rising one.

Eventually this divergence will be resolved in one direction or the other. This resolution will be an important clue as to whether the current bull market will continue or a bear market will ensue. For the Industrials to bullishly resolve the divergence, the blue-chip gauge must exceed its daily peak of point 7, which occurred on July 23rd at 11479.57. For the Transports to fail, the index would have to take out its daily low on August 6th of 2966.08. The Industrials would have to rise roughly +6% from current levels to accomplish this feat, but the Transports decline almost -15% to penetrate the previous Intermediate low. Neither of these scenarios seems likely in the near future. If that proves to be the case, then this Dow Theory divergence could persist for some time. When it is resolved, however, it is likely to set the market direction for several months -- and perhaps even several years.

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