The Dow theory is, among other useful stuff, defining the relationship of DJ industrial index and the transport index to primary bull or bear trend. It’s amazing, but the Dow theory was almost 100% correct (maybe just a little late) during all the 100 years of its existence.

But I’ve recently heard an incorrect opinion (don’t want to point the finger) that the bear market is over when DJ and transports cease to make simultaneous new lows. In that case it was pointed out that the transportation index does not confirm the new low of DJ and hence the rally is due

Before applying the Dow theory in practice you need to keep in mind that transports are the classic early cycle leader. Let look at the chart:

This is the ratio between transports and S&P 500 before and during the last bear market. You can clearly see that high inflation made transports to underperform the market for two years before the bear market started. But as soon as Greenspan cut the rates for the first time the trannies are seriously overperforming the market. It doesn’t mean that the transports index will necessary enter the bull market while the rest of the market is in severe decline, but at least it can stop confirming new lows of Dow Jones index.

I think by its nature the classic Dow theory signal is much more reliable at the beginning of the bear market but it can give a premature optimistic signal of a new bull market.

Lets look at the recent chart:

It seems to me that the ratio gave a pretty good one year advance bear market warning in 2006. Then it gave a very bold confirmation in October and then quickly fell to the levels that remind of the early 2000 a the first chart. The time seems very compressed and the run that follows is very similar to the early 2001.

Knowing that the previous bear market was running till the Fall of 2002 we can conclude that the chart as we see it now keeps the door open for a nice deep and protracted bear market even if transports will fail to make new lows