What does a Dow divergence mean to investors?

February 21, 20121 Comment

Divergence between the Dow Industrials and the Dow Transports is considered a warning sign if you follow the Dow Theory. Right now, transports are diverging from industrials. While the industrials have been making new highs, the transports have clearly begun to trend lower. According to the theory, when one of these averages climbs to an intermediate high, then the other is expected to follow suit within a reasonable amount of time. If not, then the averages show “divergence” and the market is expected to correct. On the chart above, the Industrials are the line-graph (making new highs) while the transports are represented by the candlestick graph (trending lower since early February). 

 

Interestingly, this market continues to defy the odds by moving higher in the face of a number of normally accurate reversal indicators:

  • Momentum indicators began rounding over a couple of weeks ago 
  • The S&P 500 is bumping up against the very strong resistance it hit & failed at several times last summer 
  • Market leadership from Apple (AAPL-Q) may be taking a pause based on last weeks $30 reversal on the stock. 
  • Fundamentally, some research analysts may argue that there is value in the market, but the Shiller trailing PE ratio is pushing 23 right now. A quick look at the chart for this ratio at www.multpl.com shows us that the trailing PE is not cheap, and is in fact getting uncomfortably close to the danger zone for this indicator.

 

I remain 80% invested in my equity platform. The 20% cash is my bet on a modest pullback, to be used to buy equities  at lower prices. Seasonal factors give us a few more months of upside before we should become overly cautious despite the factors I’ve mentioned above. Nonetheless, most of the positions I hold (with the exception of some energy and base metal holdings) are focused on higher dividend and/or lower beta stocks. I hold a fairly large allocation in Canadian financials, along with various infrastructure, utilities, and select high quality blue chips. I’m participating and profiting in this market, but taking a bit of a cautious approach while doing so. I may underperform the averages by exercising caution at this time, but I’ve found that its been a more profitable strategy to limit your risk when the potential for a correction increases.

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