No turnaround confirmed yet

A cornerstone of Dow Theory is confirmation. Dow Jones used industrial and railroad indexes as indicators of the state of the economy and business. Confirmation is the process of comparing two averages, to assert the direction of the primary trend. What this means is that if the one index reaches a new high, yet the other index doesn’t, it means the primary trend is running out of steam. If one index reaches a new high, then the other index should also, around the same time. They don’t need to reach new highs or lows at exactly the same time – a few weeks is acceptable. The primary and secondary indexes should perform together. If not, a divergence suggests a reversal is likely.

The secondary index should complement the primary index. The secondary index should also consist of securities that are completely different from those in the primary index. For instance in Dow’s time he used the industrial and rail indexes. Today the modern version of the rails index is the transportation index. The American transport index is the Dow Jones Transportation Average. On the Johannesburg Stock Exchange (JSE), the equivalent index is the Industrial Transportation Index (INDT – Black Line Chart).

JSE INDT TOPI

JSE INDT TOPI

If we compare the JSE’s Top 40 Index (TOPI – Blue Line Chart) with INDT, we can clearly see that the Top 40 reached a new high on 20 June 2007, yet INDT failed to reflect this peak. On 6 March 2008 another divergence occurred, when the Top 40 reached another new high, and INDT continued its downward trend. On 22 May 2008 the Top 40 reached its all time high, and the INDT yet again told us otherwise.

What can we say about the past 5 months? Well it looks as if the Top 40 is trending sideways, and INDT is continuing its downward trend. This is yet another divergence. Not as strong as the ones produced during 2007, and 2008, but still suggesting that the Top 40 might fall even further than its lowest point on 20 November 2008. It looks like the Top 40’s current support is around the 16000 to 16800 range. On the 3rd of March 2009 INDT reached an all time low, but TOPI has not yet reached an all time new low. I believe there is a strong likelihood that the TOPI  will continue trending downwards during the next 6 weeks, and reach a new low. It will be interesting to see if this is indeed the case.

What’s so powerful about Dow’s confirmation is that it provides a strong early warning signal that the big trend is changing. In the recent past we were warned almost a year before the JSE finally came crashing down.

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