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One Plus One Equals... 

If you were to run back through the last couple of decades, you would find that the general trend for the DJII can be explained by a combination of the Dow Transports and the long end of the bond market. While this may not seem like a huge revelation, it still helps to explain some of the action over the past number of months and offers a glimpse into the futures as well.

We show comparative charts of the Dow Jones Industrial Index and the sum of the T-Bond futures (multiplied by 28) and the Dow Jones Transportation Index. The bond market, by way of explanation, was multiplied by that number to give it an approximate equal weighting with the Transports.

Besides being a simple curiosity, what information do we get from this? Well...the Dow Theory suggests that the divergence between the Transports and Industrials is massively negative and will lead to the end of the world as we know it (editorial license). Yet, the markets either aren't paying attention or couldn't care less. Is there something that Dow Theory adherents are missing?

The equity markets are affected by both growth and interest rates. If bond prices are falling, the equity markets tend to struggle. On the other hand, the equity markets can still rise if growth collapses IF bond prices are rising fast enough. The worst case scenario, usually associated with a recession, would be collapsing growth AND rising interest rates.

The charts show the period from 1995 to the present day and from 1985 through to the end of 1990. The similarity between the broad trends is readily apparent, but so is the fact that the Transports/bonds combination tends to peak in advance of the DJII. In fact, the only time that one should be concerned that DJII weakness does not present a buying opportunity would be after a major divergence has been set. In the 1987 example the move by the DJII to new highs without the Transports/bonds indicated a potential crisis.

In the very short term, conditions for the broad market seem relatively positive, as the Transports have broken out of a major channel and bond prices keep crawling higher. What worries us, and helps keep out negative posture intact, is that the divergence is not only in place, but very old. Keeping in mind that the Transports/bonds have to peak, move lower, and then fail to confirm DJII strength on the next recovery, the entire process can be stretched over many months. In fact, in both 1987 and 1990, it took almost 5 months EXACTLY between the time the recovery began and the equity markets buckled. As the latest recovery began in early March, that means that this recovery has take...five months as well. Are we on the edge? Quite possibly. The next sharp break to the downside in the bond market may well indicate that the party is over.

Inter-Market Relationships Analysis
Kevin Klombies Editor/Publisher
www.krk-imra.com

August 3, 2000