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CONFIRMING AVERAGES For the past several weeks, I've explored several of Edwards and Magee's 12 major tenets of stock market analysis in this column. (If you're a new reader, then note that Edwards and Magee are authors of the classical text -- Technical Analysis of Stock Trends, which I introduced you to in our July 28th StreetAuthority Swing Trader issue.) In the course of my recent "Inside The Black Box" analysis, I've provided you with specific definitions of the Primary, Intermediate and Minor trends, and have given you a better sense for their typical percentage moves and durations. This knowledge, I believe, is essential to accurate chart analysis. It is vital to swing trading success, which derives in no small measure from the ability to accurately label and trade the three overall market trends and to apply this analysis to stock selection that is in harmony with the broader market's direction. Thus far I have applied Edwards and Magee's comments to the S&P 500, which I use as the key definer of the contemporary U.S. stock market. Edward's and Magee's initial focus, of course, was on the Dow Jones Industrial and Transportation averages -- the dominant market measures of their day. A core principle of their theory is that "the two averages must confirm." That is, before the market can signal a change in the Primary trend, both averages have to send the same technical message. The Dow Jones Averages go back to the work of Charles Dow, after whom the Dow Jones Industrial Average is named. In 1884 Dow put together an 11-stock average. Of these, 9 were railroad companies -- the dominant enterprises of that time. The average was not meant as a stock forecasting tool, but rather to help forecast overall economic trends. In 1896 a 12-stock Industrial Average was created and the "Rails" expanded to a 20-stock average. Since the Industrial companies manufactured products and the Rails moved these goods to market, it made sense that a move in the stocks of one average should be confirmed by the other. When both averages signaled a change in Primary trend, traders then had "confirmation." When one average created such a signal, but the other average did not confirm, then the condition was called "divergence." The two averages need not create the signal at the same time, but the longer it is delayed, the more reason there is to suspect the validity of the signal. I've presented you with weekly charts of the Dow Jones Industrials and Transports below. In early October 2002 the Industrials made their bear market low at what I've labeled "Point A" at just above 7,500. (Since a key principle of Dow Theory is to use only closing prices, I've ignored the extreme intraweek low.) By December of that year, at "Point B," the index rallied back to a closing level just below 9,000.
The decline into March 2003 took the index back to a low near 7,800 at "Point C." This low was, of course, significantly higher than the October 2002 bottom. However, at this point we had not yet seen a change in the Primary trend. That signal was not given until "Point D" in June 2003, when the Industrial Average finally managed to take out its December high by closing above 9,000. From the point of view of the Dow Jones Industrial Average, a reversal in the Primary trend from down to up had occurred. (Note that all pullbacks since June have held very close to the 9,000 level.) The picture presented by the Transportation Average is much less clear-cut. (The Transports combine rails, truckers and airlines and are the successor to the "Rails"). In October 2002, at "Point A," the Transports reached a closing low of just over 2,100. A rally then took the index to a closing high of just over 2,400 in very early January 2003 at "Point B." A steep decline then brought the Transports back to a close just above 2,000 in March of this year -- "Point C". Note, that this low was lower than the low we saw at "Point A." In March, then, we saw a divergence, as the Industrials had held a former low, yet the Transports violated their previous bottom. Since that time, however, the Transports and the Industrials have been in sync. In late April, at "Point D," the Transports were able to rally above their previous Intermediate January high. The pattern was now that of a lower low, but a higher high. As I interpret the two charts, the Transports have yet to signal that their Primary downtrend is over.
What will it take for the Primary trend to turn positive? From my viewpoint, the Transports will need to put in an Intermediate decline. Such a decline would reverse an approximate minimum of 1/3 of the previous advance, which has been 600 points. Therefore, from this level the index would need to correct to approximately 2,400. It would then need to rally back above its July highs ("Point E") near 2,600. This pattern would then confirm the move of the Industrials and would turn the Primary trend of both averages up. How seriously should swing traders take the idea that the "two averages must confirm?" Clearly, this viewpoint is less valid than when it was first formulated (when the major indices consisted of just the Industrials and the Rails). However, I think the idea still has power. First, Dow Theory still has many followers, not the least of whom are gurus such as Richard Russell. Second, the Industrials and Transports are major averages and their price action is key to how traders see the economic prospects for these sectors. When both averages give the same message at or near the same time, they are much more likely to communicate important information on stock market trends. When integrated with analysis of the S&P 500 and Nasdaq, Dow Theory provides a valuable key to accurate stock market and swing trading prediction.
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