Why the Dow Theory Market ‘Crash Warning’ Signal is Still Relevant Today

This isn’t good news for stock lovers. As the Financial Times reports:

Wall Street’s comeback petered out on Tuesday, with the S&P 500 falling by the most in almost a month and several market indicators showing increasing signs of strain.

The S&P 500 stock index fell by 1 per cent on Tuesday — its worst performance since March 8. Meanwhile, certain gauges of the market’s and economy’s health are flashing warning signs that the relative calm that descended over the financial markets in recent weeks could be about to end.

“The fundamental portion or our global growth checklist remains weak, which is a headwind for risk-on factors,” said Dennis DeBusschere, head of portfolio strategy at Evercore ISI.

That’s not good. If you’ve followed my market ‘crash warning’ signals, you’ll know that I watch the US S&P 500 index closely. In particular, I’m watching the trend of actual and forecast earnings (profits).

This latest news from the US is reason enough to revisit the chart we’ve shown you several times. You may get tired looking at it, but we’ll never get tired of showing it to you.

If you recall, this chart shows actual and forecast earnings for companies in the S&P 500 index. The white line to the left of the green line shows actual reported earnings.

The white line to the right of the green line shows forecast earnings.

Source: Bloomberg
Click to enlarge

Actual earnings are in decline, and have been since early last year. I’ve added the red arrow to emphasise the point.

And yet, despite falling earnings, Wall Street analysts still predict a bumper earnings season for US companies over the next three years. You can see the typical step-up pattern.

Interestingly, the FT article references another of our market ‘crash warning’ signals:

Meanwhile, the Dow Transportation Average, which is seen as an economic barometer because of its components’ central role in moving goods around the world, has fallen below its 200-day moving average, a support level that is watched by market technicians.

The fall in the Dow Transportation Average below that level could be an ominous sign, given moves in the index sometimes precede the broader market. For instance, the average hit its bottom in January about a month before the broader markets notched their lows of the year.

The relationship between the Dow Industrials and the Dow Transportations is important. It’s known as the ‘Dow Theory’.

The chief proponent of the Dow Theory in recent years was Richard Russell, who passed away late last year.

It’s a hotly debated theory. Mainly because no one is 100% sure about when the Dow Theory is signalling a potential market crash or rally.

But one of the key parts of the Dow Theory is the idea of non-confirmation.

That is, if the Industrials hits a new high and the Transportation index doesn’t ‘confirm’ that high by hitting a new high too, it suggests that the strength in the market may not be genuine.

As it happens, we appear to have a non-confirmation situation at the moment, as evidenced by the chart below:

Source: Bloomberg
Click to enlarge

The green line is the Industrials. It recently rebounded up towards the record all-time high. However, the Transportation index (white line) started moving the other way.

That could tell you that investors don’t see the same strength in the earnings potential for transport stocks as they apparently do for industrial stocks.

As the FT article notes, that could be worrying. Even in an online and service economy, there is still the need to shift things around from place to place.

Take Amazon.com Inc [NASDAQ:AMZN] as an example. It has had a huge disruptive influence on retailing by driving a lot of the retail economy online.

Yet, much of what it sells requires goods to be shipped from one place to another. Even though it’s easy to think of transportation stocks, and the relationship to the Dow Industrials as something from the dark and distant past, the reality is that it’s still relevant today.

We’re continuing to watch both of these ‘crash warning’ signs, and we suggest you do too.

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Publisher, Money Morning

Ed note: The above article was originally published in Port Phillip Insider.

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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