Why Dow Theory isn't a red flag for the market

Many savvy market pundits have observed, of late, that the Dow Jones Transportation Average is noticeably underperforming the Dow Jones Industrial Average, raising questions about this phenomenon as a potential yellow — or even red — flag for the market.

Workers prepare to offload an incoming FedEx plane in Newark, New Jersey.
Andrew Burton | Getty Images
Workers prepare to offload an incoming FedEx plane in Newark, New Jersey.

"Dow Theory" suggests that when the industrials and transports are moving up in tandem, a bull market is in force and the economy is chugging along at a healthy clip. By the same token, if the averages part ways, it could be viewed as a warning sign that something in the economy is out of line.

To put it more plainly, the Dow industrials represent the output of the economy (read: supply). The transports represent the vigor of the economy (read: demand). If the industrials are roaring, but the transports are faltering, the economy might be oversupplied with goods — a sign that demand is waning. That is viewed by some as a "sell" signal for the market.

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If the industrials are heading to new highs while the transports are heading to new lows, a "Dow Theory Divergence" is created, suggesting that there are too many goods being produced amid flagging demand.

The theory has generated many important sell signals, but a few head fakes as well.

Lately, the Dow transports have underperformed the industrials. That may not be the same thing as a "divergence," or "sell signal."

While transports have sold off, oil prices have shot up to nearly $60 a barrel. That means the cost of being in the transportation business is going to be higher than when oil was in the low $40 range. It doesn't necessarily mean that demand is slowing down. Hence, an underperformance isn't necessarily a meaningful divergence.

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Indeed, the airline industry is expected to have the busiest summer travel season ever this year, the trade group Airlines for America recently said, citing the stronger economy.

We have not, as yet, been given dire forecasts from shippers, truckers or railways either, with respect to final demand. So, for the time being, we cannot claim that the Dow Theory is flashing a warning signal for the stock market.

Also, from a chart-watching perspective, there are three distinct parts to a Dow Theory divergence. First, the two averages rally to new highs together. Then, they experience a correction … together. The final stage sees the industrials going to new highs, while the transports break down and make a succession of new lows for the move.

Year-to-date, the industrials are up 2.6 percent and the transports down 4.3 percent. While it looks like a divergence, at the moment, the relative underperformance of the transports could be quickly erased by a rapid drop in oil prices.

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The true test will come if the industrials move to new highs from here, and the transports break down even further. That would be a meaningful divergence and suggest a Dow Theory "sell" signal. In that case, it would be time to catch a train departing Wall Street Station. For now, it is a light yellow flag. Any deeper divergences and that flag will go from pale yellow to flashing red.

Commentary by Ron Insana, a CNBC and MSNBC contributor and the author of four books on Wall Street. He also editor of "Insana's Market Intellgence," available at Marketfy.com. Follow him on Twitter @rinsana.