When the transports diverge, or fail to make new highs while industrials are making new high, this can be an advanced warning of a correction. I’ve made a point of warning readers of Dow divergences or non-confirmations by the transports on this blog in the past. For those who follow my blog, you will know that this is a pretty reliable leading indicator for advance warnings of corrections. For reference, please see this blog, which presented a video of the divergence seen last May. That Dow divergence signal was one of the leading indicators that helped me sidestep last summer’s shellacking.
The chart below will be a little hard to see the details on, given that it encompasses 25 years of data. But I wanted you to see the historic returns after a market divergence by the transportation stocks against a new high by the industrials. I’ve circled divergences by the transports in 1992, 1999, 2007 – and currently from 2015. Each of these divergences lasted a while before the proverbial poop hit the fan. But in every case noted, the divergence did lead into a correction of some sort. The 1992 divergence lead into a late-year minor correction, while the 1999 and 2007 divergences lead into major stock market crashes. The 1994 divergence was a false signal.
I should note that sentimentrader recently studied the coincidences of transports failing to reach new highs with industrials, and found it to be less concerning.
But their research focused on the timing and coincidence of a new high in conjunction with a pending correction. What I am trying to illustrate here is that, despite the lack of precision in timing a correction, the longer a divergence between these indices, the bigger the case for a significant market correction. Given that we’ve not seen a new high in transports for well over a year—AND that it’s been in a general bearish trend – I’m inclined to take this signal seriously.
Other factors to consider is the seasonal tendency for weakness in the later summer months into the fall, the tendency for second termed elections to be weak (as noted by Jon Vialoux’s research on my blog last week, and other factors noted on that same blog.
My conclusion is that we should keep an eye on the markets for signs of deterioration. I am 80% invested right now with no hedges in place (just 20% cash), but that could change at any time to a more cautious stance.
Here is the G&M article and video for our BNN Top Picks last Wednesday
I will be at the MoneyShow on Friday Sept 16, 2016> I’ll be speaking at 12:45pm. Here is the speaker lineup.
It should be noted also that the market as a whole has not broken out. Only the SPX and today the Dow have broken out.
With Dow divergence–we only look at the dow indices–not the broader NYSE
But to your point Bert, the lack of new high on the broader NYSE index is a sign of poor breadth. Another factor to consider…
WILL THE EARNING GUIDANCE FOR THE COMING QUARTER BE RELEVANT IN ANY WAY?
THE VIX IS NOW AT 13 AND THE PMO IS POINTING TO MORE COMPLACENCY.
Earnings may be a catalyst to a correction–and yes, the VIX is approaching my “over complacent” level of 12–that, along with seasonality, election cycles and certain sentiment studies (put/call) make me a bit suspicious.
What does the smart money/dumb money indicate? I heard you say that dumb money is buying and smart money is selling on BNN but is it at extreme levels? I find this rally to be unusual. Thanks
Funny you should ask–the smart money is not yet at extreme low confidence, but dumb money IS at extreme high confidence. So–I would expect the smarties will reach their extreme level pretty soon, which would generate a macro-bearish signal. It is not a precise timing tool, but one that should usually be heeded, even if you play it early and miss out on a bit of fun. I promise I will blog mid-week on it