Transports On The Verge

5/7/2012


The Dow Industrials reached fresh four-year highs, edging above the high reached in early April. But the Dow Transports have not reached a significant high since closing at 5,368.93 on Feb. 3, so a move above that level is needed to reconfirm the bullish primary trend. For now, we intend to watch the averages while maintaining 90% to 93% of our buy lists in stocks.

Both averages must confirm

Confirmation — the idea that both the Industrials and Transports must reach significant highs (or lows) for a valid bull-market (or bear-market) signal — is central to the Dow Theory. As founding Dow Theorist William Hamilton wrote in 1928, "Half an indication is not necessarily better than no indication at all. The two averages must confirm each other."

While nothing says the Industrials and Transports must hit new highs simultaneously, an indication is stronger when both reach new highs around the same time. And when one average stubbornly fails to confirm a series of new highs in the other, as seen since early February, the divergence signals uncertainty regarding the primary trend.

Some argue the divergence has gone on much longer, as the Transports have not reached fresh post-2009 highs since July. But we view the downturn that ended Oct. 3, which saw declines of 17% in the Industrials and 28% in the Transports, as a bear market. That means the July high is no longer relevant to the status of the current bull market, at least according to Dow Theory.

Looking beyond the Dow Theory, we'd view a move above the July all-time high in the Transports of 5,618.25 as encouraging, especially if accompanied by a move above the Industrials' 2007 all-time high of 14,164.53. With moves above those points, which are less than 7% from current levels, the market's long-term trend would be unequivocally bullish.

Upside breakouts in the S&P MidCap 400 and S&P SmallCap 600 indexes would also be encouraging, as both have been moving mostly sideways since early February. Like the Transports, small and midcap stocks tend to be especially sensitive to expectations for the economy.

Conclusion

The last important signal under the Dow Theory came in December, when the Industrials and Transports moved above their October highs. While the Transports' inability to confirm new highs in the Industrials is trying our patience, we are sticking with a mostly invested posture. A mere 0.8% rally would put the Transports at 5,368.93, and we are still finding quality stocks at reasonable valuations. Top year-ahead picks include Apple ($582; AAPL), Intel ($29; INTC), and Macy's ($41; M).


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