Dow Theory divergence: a warning, or an opportunity?

September 27, 20214 Comments

In a few days, I will post my monthly reading of the Bear-o-meter. That indicator is my relative risk/reward reading of the market. The Bear-o-meter looks at trend, breadth, breadth-momentum, value, sentiment and seasonality. One of the breadth indicators within the compilation is a Dow Theory tenant. It compares the Industrial sector to the Transport sector. If Transports are diverging negatively against the Industrials, this can be a bearish sign for broad markets. Right now, the negative divergence by the transportation stocks is one of the more severe ones I have seen. That’s potentially bad news for investors.

Below is the chart of the Transports (black line) vs the Industrials (red line). When transports diverge negatively for prolonged periods, as in late 2014 and  in 2019 before the COVID crash, the broad market (and Dow industrials) often corrects. When they diverge for only short periods, like during 2017, the incident is less alarming. Having said that, the multiple divergences during 2017 eventually lead into a pretty choppy 2018.

Right now, we are seeing a more significant divergence than those “mini” divergences of 2017. Take a look at the recent extreme negative trend angle of the  Transports since the beginning of 2021. Its been a long and steep period of underperformance. Will this lead the broad markets into a correction? Or, will the transports pull up their socks…. and move up? Speaking of socks, I just recorded a video called “Pull your SOXX up” that addressed a potential opportunity in the semiconductor sector.

 

To address the question of the direction of the Transports, lets look at a neartermed (daily) chart. The daily chart, below, shows us a downtrend that has yet to be broken. Momentum oscillators (stochastics, RSI, MACD) were oversold and are now looping up. The comparative strength line vs the S&P 500 (below RSI) is possibly breaking its trend of underperformance. Moneyflow momentum (top pane) is showing some life. Longertermed moneyflow is still in a bear trend.

 

Should the Transports break their downtrend by definitively busting about 14,600 – we may have a great case for buying into the sector. The Transports start their seasonal period of outperformance in a week.  The iShares Transports ETF (IYT-US) is a broad index play on the sector – and you can also view the individual stocks for ideas. But we need to see the trendline break before taking action. That has yet to be seen. Remember, a continued divergence by the Transports probably spells trouble for the broader markets. So there’s no rush to get into this play just yet.

quote-teal

4 Comments

  • Hi Keith, I recently sold my house and may have some further investible cash. My questions would include: what is your minimum and is that across multiple account types. And what about tax exposure?
    You have my email address if you would prefer to answer these questions that way.

    Reply
  • Why do you use CMF instead of MFI?
    What is the relevance of the numbers ( negative or positive) that I see in the Accumulation/Distribution indicator?

    Thanks

    Reply
    • CMF is a bit more active – but they are pretty similar. If you lay them out on a volatile stock like GE or something like that, you will find the CMF (which is a moneyflow MACD-like indicator, it compares EMA’s) is often more reactive than MFI (which is a moneyflow RSI-like indicator, so it compares price to lookback price). But hey–its not a deal breaker. Use either one–more or less the same idea.
      Many “numbers” on an indicator line are just a reference point. Just a way to view the relative move. Having said that–I do not see a numeral scale on the cumulative AD line on my charts.

      Reply

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