While the S&P 500 and Nasdaq Composite set fresh records on Tuesday, there is one red flag signaling the potential for a stock-market pullback in the near term, according to Sam Stovall, chief investment strategist at CFRA.
The broader market, measured by the S&P 500 SPX, +0.06% is up 7.4% year to date.
Over the long-term, both industrials and transports are highly positively correlated, meaning moves in one are closely tracked by the other. That’s no surprise. After all, a growing economy needs a robust transportation industry to ferry manufactured goods and transport people with disposable income.
The Dow Theory, one of the oldest technical trend indicators, triggered a buy signal in early March, when both the transports and the industrials indexes hit records at the same time. But divergence since then may be signaling a short-term pullback or a correction is in the offing, according Stovall.
Divergences over the short-term aren’t unprecedented and, in fact, happen pretty often. For example, the rolling 90-day correlation between the two indexes has now dropped to nearly zero—meaning they move almost completely independently from each other—from a perfect correlation in late 2016.
In the chart below, Stovall points out that when correlation drops to 0.2 (which is two standard deviations below the mean of 0.7)—a proverbial line in the sand—the risks of a pullback or even a correction increase.
Since at least 1994, all corrections, characterized by a pullback of 10% or more from a recent peak, were preceded by such a divergence. However, there have been many divergencies that didn’t result in corrections, so the signal should be taken with a grain of salt.
“So while Dow Theory is now signaling caution, the caution not only relates to the market but also to the infallibility of this indicator,” Stovall said in a note.
The broader market hasn’t seen a correction since February of 2016 even as valuations stretched to highest levels in years.
For example, both trailing and forward price-to-earnings ratios are at the highest levels since 2004, according to FactSet.
Stovall said Dow signals are best used to reassess asset allocation and should not be used as a market-timing tool.
Besides, the trend of buying the dip is still in full force, Stovall said.
“The S&P 500 has taken an average of only two months to recover from pullbacks and just four months to get back to break-even after corrections. So we continue to believe it would be better to buy than to bail,” Stovall said.