Dow Theory Non-Confirmation and Sell Signals

Dow Theory uses the Dow Industrials, $INDU, and Dow Transportation, $TRAN, indexes to gauge broad market direction. Reference the writings of Charles H. Dow, William Peter Hamilton, Robert Rhea, E.George Schaefer and Richard Russell for further information. As both indexes move up creating higher highs the broad maket bulls are running. If both indexes are moving down and creating lower lows, the market bears are at play.

After an up market move, one of the indexes will place a higher high, but the other will peter out and not be able to post a higher high. This flashes a non-confirmation signal telling traders that all is not well in the markets. If one of the indexes then places a lower low, the situation is deteriorating, and if both indexes print lower lows, a confirmed sell signal for the broad markets is triggered. The same idea works in reverse. As lower lows occur, the sell signal rules, but, as one index reverses and flashes a non-confirmation favoring the bulls, then as both print higher highs, the bulls regain control. These moves can occur over any time frame; days, weeks, months. Simply watch the price movement on INDU and TRAN to folllow along.  Let's take a look at the Dow Theory collapse during 2011 in more detail.

The wine was flowing after Chairman Bernanke popped the QE2 champagne cork in August 2010 as the green circles show.  Higher highs every step of the way.  The Dow Dirty Thirty and the Trannies each confirming the bullishness in the broad markets, until we move past the May period. Both indexes had confirmed higher highs thru the start of May, so the booze continued to flow like water as the bullish party plays on.  As the markets moved into summer time, note that the Transports place a higher high at 5627.85 on 7/7/11. Unfortunately, for the bulls, the Dow was languishing 200 points under its May highs with no sign of strength. As July played out, the Dow petered out, kicking off the non-confirmation signal as of 7/7/11.

The savvy traders were watching so a move towards lightening up on long positions during July, as the non-confirmation remained in place, was prudent. The key moment occurred during the 8/2/11 session when the Transports fell below the 6/13/11 LOD of 5034.61. The Trannies closed below the June low that day.

The final nail in the coffin would occur with the Dow Industrials.  In the 8/3/11 session, the Dow took out the 6/1611 LOD at 11821.96.  On 8/4/11, the Dow fell under the June low with a closing lower low to lock in the sell signal for the broad markets. Thus, as of 8/4/11, Dow Theory told you the bears were in full control of the broad markets.

Currently we are now in a period of lower lows for the two compadres, so keep watching. Next on tap is if the Dow prints another lower low, or not.