Should You Heed Dow Theory’s Warning?

Editor’s note: Beat the Bell editor Serge Berger will be filling in for Sam Collins until May 26.

Wednesday was another fantastically boring day on Wall Street as the Dow Jones Industrial Average fell 27 points and the S&P 500 lost just 2 points.

The only short-lived excitement for the broader market came after the FOMC minutes were released and showed that most Federal Reserve officials did not think economic data would warrant a rate hike in June. This led to a mini-rally in stocks and bonds. In typical 2015 fashion, though, the intraday rally deflated into the close. Total volume on the New York Stock Exchange came in a smidge better than Tuesday, but still fairly dismal.

Dow Jones Industrial Average Chart
Click to Enlarge

Both the Dow Jones Industrial Average and the S&P 500 are snoozing marginally above their year-to-date trading ranges. In the bigger picture, they remain in a low-momentum state that, as I have discussed over the past few days, favors more choppiness and suggests active investors should build larger cash positions.

The big story from a price action perspective on Wednesday came from the transportation stocks. The iShares Dow Jones Transport. Avg. (ETF) (NYSEARCA:IYT) dropped 2% on the day and looks to be gaining downside momentum.

Led by airlines, the Dow Jones Transportation Average had one of the worst single-day declines this year. So, with the Dow pushing against new all-time highs and the transports slumping, we have a clear divergence and Dow Theory warning signal.

IYT Chart
Click to Enlarge

The chart above shows IYT in the upper panel and the Dow in the lower panel. Note the series of lower highs in the transports since November and how this is visibly putting pressure on the horizontal support line. With Wednesday’s selling, that line has been broken with better force twice since early April, and it now favors a continuation lower.

The divergence between the Dow Jones Industrial Average and the Dow Jones Transportation Average is well covered by the media, but by itself is not a sell signal. Empirically, in bull markets such divergences occur often and then simply lead to the transports catching back up with the industrials.

At the same time, many important intermediate-term tops in the stock market also feature this divergence. Considering the increasing warning signs from within the stock market and other asset classes, I am heeding the call from slumping transportation stocks. In fact, I am interested in opening a pairs trade whereby I would sell short IYT and buy SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA).

Today’s Trading Landscape

To see a list of the companies reporting earnings today, click here.

For a list of this week’s economic reports due out, click here.

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Download Serge’s trading plan in the Essence of Swing Trading e-book here. As of this writing, he did not hold a position in any of the aforementioned securities.

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