A more than century-old stock-market indicator is flashing a bearish signal that could mean more pain ahead for investors.
Specifically, a bearish divergence has formed between the Dow Jones Transportation and Dow Jones Industrials Averages in recent weeks after the transports made a new higher high in early February while the industrials average languished sideways.
The method of analyzing the intermarket relationship between industrial and transportation stocks is called «Dow theory,» which was coined by S.A. Nelson and refined by William Hamilton and Robert Rhea in the 1930s. The original idea comes from Charles Dow, founder of the Wall Street Journal who published hundreds of editorials on the topic before his death in 1902.
The general idea is that both averages over time should move in tandem, given that the transportation average represents companies responsible for the movement of goods across the country. For that reason, it should serve as a leading indicator.
The transportation index, whose origins date back to the late 19th century, is made up of a slew of transportation stocks including logistics companies such as FedEx and UPS, airlines, and railroad operators like Union Pacific.
Dow theory suggests that the relationship between the two indexes could send a broader signal to investors about the future direction of the stock market.
The transportation and industrial averages should ultimately confirm new highs or new lows in the market, and when they don’t, investors should start to pay close attention.
The initial bearish signal from Dow Theory flashed in early 2022 when the industrials average made a new record high and the transportation average failed to follow suit. Now, the exact opposite is happening, with transportation stocks leading the way higher while the industrials average flounders.
«The Dow Jones Industrial Average and the Dow Jones Transportation Average have struggled to move to new highs together, which is needed to suggest a more bullish setup for Dow Theory,» Bank of America’s Stephen Suttmeier said in a Tuesday note.
«These bearish divergences into late 2022 and early 2023 show a disconnected equity market, keeping the bearish signal for Dow Theory from early 2022 intact,» Suttmeier said.
For now, Suttmeier said sentiment whipsaws between bullish and bearish investors makes for a stock market that has little conviction in which direction to move in, just like the Dow Jones Transportation and Industrial averages.