thE hAnDbook of tEchnicAL AnALySiSFigure 9.94 shows the various divergences that exist between the Dow Jones
Industrial Average and the Dow Jones Transportation Average over a period of
five months. The Transportation is represented by the line chart. Assuming that
the Dow Jones Transportation Average represents the supporting data series, we
expect the Industrials to follow through in the direction indicated by the Trans-
ports for standard divergence and in the opposite direction to the Transports in
reverse divergence. We see that the Industrials do in fact react to the Transports
in the manner expected fairly consistently, as evinced by the price excursion at
points 1 to 4. For example, we see the Industrials declining at point 2 after a
standard bearish divergent setup and subsequently rising, as expected, at point 1
after a reverse bullish divergent setup. The Industrials rise again in similar consis-
tent fashion at point 3 after a second reverse bullish divergent setup and decline,
as expected, at point 4 after another standard bearish divergent setup. This is all
predicated on the assumption that the Transports lead the Industrials.
In Figure 9.95, it is assumed that the Baltic Dry Index will lead the broader
market, represented by the S&P500 Large Cap Index (SPX). The Baltic Dry In-
dex is a fairly accurate barometer of future economic activity, which in a way is
analogous to the relationship between the Dow Transports and Industrials. Unlike
the previous example where adjacent peak to peak or trough to trough analysis
is employed, divergence is identified in this example using conventional trend and
slope analysis. Therefore it can only be interpreted in terms of standard bullish
or bearish divergence. We see the two indices diverge after a prolonged period of
being fairly positively correlated. Based on our assumption, this setup is therefore
bearish for the broad market.
Another way to identify divergence between two data series that have a con-
sistent history of being very positively correlated is to look for periods when the
correlation starts to breakdown. This can be seen in Figure 9.96 at points A and
B. The chart tracks the market action of the S&P500 against an inverted Volatility
Index (VIX). This is done to help better visualize the relationship between the two
Figure 9.94 Intermarket Divergences.
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