MARKETS SPECTATOR: Is a pullback just around the corner?

Divergence between the Dow Transportation Index and the Dow Jones Industrial Average could be warning of a downwards trend ahead.

Where markets are headed in the short term is a hot topic at the moment. So far, they’ve been bucking seasonal weakness and largely holding steady, thanks to the recent announcements of stimulus from the US Federal Reserve, the ECB as well as the Bank of Japan.

One commonly touted warning sign, especially among market technicians that study price action rather than the actual underlying values of assets, is a divergence between the Dow Transportation Index and the Dow Jones Industrial Average.

According to Dow Theory, for the market to be trending both the Dow Transportations and Dow Jones Industrial Average indexes should be in sync, with both confirming the price action of the other. When these two indexes diverge, as we are seeing at the moment it is commonly seen as a warning sign for a possible change in trend.

The Dow Transportation index represents 20 stocks comprising airlines, railroads and trucking companies. The theory is based on the relationship that exists between companies that make products and companies that transport them. It is said that a weak transportations index reflects a softening of the transportation environment, which is viewed as an overall leading indicator of economic health.

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Source – Aspen Graphics / Bloomberg, September 20, 2012

In the last few months, we’ve seen quite a big divergence in the two indexes, as can be seen on the above chart. In fact, it is rather reminiscent of the divergence seen during mid-2007 which resulted in a correction for the Dow Jones Industrial Average. As this situation has developed, there has been no shortage of market commentators citing the divergence as the reason we’re on the verge of an impending correction. However, as always there are two sides to the story.

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Source – Bespoke Invest Group

The above chart indicates that while significant, the current spread between the two indices is by no means abnormal. Whilst there could easily be a correction in the industrials index, there could just as easily be an upside correction in the Dow Transportations index following its recent underperformance.

Another worthwhile point was put forward by Jim Cramer, co-founder of TheStreet and regular markets commentator. He noted that "this rally has not been built on industrial stocks. It’s been built on consumer packaged goods, health care, financials, telecom, the internet and Apple. These winners aren’t shipped. So the weakness in transports, while important, simply isn’t that representative of what’s going up.”

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