The Smart Profits Report – Sector Watch

Monday, May 19, 2008

Taking Aim At The Record-Setting Dow Transports

by Jim Stanton, Technical & Quantitative Analyst, Smart Profits Report

Since the Bear Stearns blowup on March 17, two stock indexes have clearly led the way
ahead.

The first is the S&P 400 Midcap Index (^MID), which closed well above its 200-day
moving average last week. It’s not entirely surprising that this index has performed well,
given investors’ major wariness with large-caps in the wake of the Bear mess.

But the other strong performer is something of a surprise. Not only did it also close well
above its 200-day moving average, it also made new all-time highs this morning.

I’m talking about the Dow Jones Transportation Index (^DJT). This is a remarkable
feat, given the huge oil price runup to record highs, and the underperformance of
airline stocks.

I’m going to dig a little deeper into this index today, using the ETF that represents it –
the iShares Dow Jones Transportation Average (NYSE: IYT)…

Understand The Theory To Unlock The Profits

In order to understand the current movement of the Dow Transports – and where the
index might go next – we need to apply a quick bit of theory. Dow Theory, to be exact…

Last week, all the stock indexes traded at new recovery highs. All except the most
widely followed one, of course – the Dow Jones Industrial Average (^DJIA), which is
trading just a few points shy of its May 2 high.

This creates a minor “Dow Theory” divergence. Simply put, Dow Theory means that
both the Dow Industrials and Dow Transports have to make new highs together in order
for a bull market to stay intact. The same theory goes for a bear market – both indexes
have to make new lows around the same time (allowing some time for the lagging index
to catch up) in order for a bear market to continue. When one index does not confirm
the other, within a reasonable amount of time, there is a good chance for a reversal in
both indexes.

While you’ll find a few different interpretations of Dow Theory and how it triggers buy
and sell signals, I prefer to use this simplest form of it to guide my analysis. So let’s get
to it…

Dow Theory In Action

Since last July, we’ve seen a Dow Theory sell signal and Dow Theory buy signal on the
Dow Industrials and Dow Transports.

If we take a look at the weekly charts of both indexes, we can see when they occurred,
so you can better understand how this works – and how to apply it to your investment
strategy.
As you can see, both indexes set record highs in July 2007 before a correction set in.
This means the indexes were still under a Dow Theory buy signal.

The Sell Signal: The Dow Industrials went on to make new closing highs in October
2007, but the Dow Transports were lagging badly and set up a Dow Theory sell signal,
which led to more than a 2,000 point drop in the Dow Industrials.

Over the final part of 2007, both indexes sold off and made new correction lows in late
January. This signaled that they were still under a Dow Theory sell signal.
The Buy Signal: In mid March, the Dow Industrials made a new closing low for the year,
but the Dow Transports fell well short of doing the same. As a result, the indexes
reversed course, due to a new Dow Theory buy signal, which so far is still in force.

Dow Theory signals do not occur that often, but it’s well worth your time to check on
them occasionally for potential reversal points. So with that in mind, let’s break down
the Dow Transports a little more, using the index’s ETF…

Follow The Leader – The Dow Transports

I consider the Dow Transports to be a leading index indicator. For example, more often
than not, it’s the index that creates the divergence (although I’ve seen it occur in reverse
on more than one occasion, too). The dates in red on the charts above are when the
divergences occurred.

Here’s the weekly chart of IYT…

This morning, IYT traded above its July 2007 high, which is also a record high for the
stock. Having run some analysis through my ESP Profit System trading platform, the
next intermediate-term upside target for the stock is up around $107.85.

However, since we’re dealing with a weekly chart, it could take weeks (and possibly
longer) for IYT to reach its resistance area.

But here’s the thing: Because the Dow Industrials are currently more than 8% below
their October highs, the Industrials will have to play catch-up in order to avoid another
Dow Theory sell signal.

However, as long as the Dow Industrials are moving higher, or even go into a sideways
consolidation pattern, without triggering a daily sell signal, we have to allow some time
to confirm the move. In this case, it could take a matter of weeks.
Shorter-Term Outlook

As I mentioned, there is a minor Dow Theory divergence in place at the moment. But if
the Dow Industrials can trade above 13,133 – its May 2 high – the rally should
continue. In addition, because the S&P 500 and NYSE Composite are at new recovery
highs, the Dow is likely to follow suit.

However, if it fails to get above 13,133, and instead closes below its uptrend line around
12,860 (the line drawn off the March lows), be very cautious. A move below 12,715
would trigger a minor Dow Theory sell signal.

Bear in mind that because some of the indexes have rallied over 20% since the mid
March lows, they’re getting overbought, so we’ll probably see a more meaningful
correction once the rally runs out of steam.

Until next time…

Jim

Visit the Smart Profits Archive

Jim Stanton brings an incredible expertise to the E.S.P. Profit System for Mt. Vernon
Research. He's worked in the financial markets since 1980 as a stock and bond broker,
trader, and management consultant and his impressive quantitative and technical
systems have generated outstanding gains for private investors and hedge funds.

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