The fourth tenet of the Dow Theory states that market averages must confirm each other. As per the Dow theory, a major turnaround from a bull to a bear market cannot be signaled unless both indexes are in agreement. This means, that if one index confirms a new primary uptrend but another index remains in a primary downward trend, then it is difficult to assume that a new trend has begun. Therefore averages must exceed a previous secondary peak to confirm the inception or continuation of a bull market. Note that signals do not occur simultaneously, but it is recognized that a shorter length of time between the two signals provides stronger confirmation. Dow therefore assumed that when the two averages diverged from one another, the prior trend will still be maintained.
For Example: If manufacturer’s profits rises this means that they are producing more and if they produce more, then they have to ship more goods to consumers. Hence, if an investor is looking for signs of health in manufacturers, he or she should look at the performance of the companies that ship the output of them to market.
Thus the two averages should be moving in the same direction. When the performance of the averages diverges, it is a warning that change is pending.
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