Dow Theory Flashes Classic Stock Market Warning

 gross domestic productThe Dow Theory, a reliable indicator of stock market and economic direction that has been around for almost 100 years, is flashing a warning signal.

The Dow Theory looks at the relationship between the Dow Jones Industrial Average and the Dow Jones Transportation Index.

The Dow Jones Industrial Average is an index made up of the stocks of 30 large American corporations. The average includes companies like Kraft Foods Inc. (NYSE/KFT), General Electric Company (NYSE/GE), Bank of America Corporation (NYSE/BAC), and IBM Corporation (NYSE/IBM).

The Dow Jones Transportation Index is an index of the largest transportation companies in the U.S. From railroads—Norfolk Southern Corporation (NYSE/NSC)—to airlines—Delta Air Lines, Inc. (NYSE/DAL)—to trucking—C.H. Robinson Worldwide, Inc. (NASDAQ/CHRW)—to marine transportation—Overseas Shipholding Group, Inc. (NYSE/OSG).

The Dow Theory states that the rise or fall in the Dow Jones Industrial Average must be confirmed by a rise or fall in the Dow Jones Transportation Index. This makes sense, because if the economy is growing, large corporations will do well and, in turn, ship more goods and services across the U.S. and around the globe, which means that the transportation companies will directly benefit and their stock prices will rise, too. The opposite also holds true.

The Dow Theory has been a very good tool over the last 100 years for calling market tops and bottoms.

Since 2009, the Dow Jones Industrial Average and the Dow Jones Transportation Index have been following each other closely. Something happened after February 3, 2012, however. The Dow Jones Industrials continued to climb higher, reaching a four-year high of 13,000 (which I predicted), while the Dow Jones Transportation Index has fallen three percent since then.

Recently, I introduced you, dear reader, to the Baltic Dry Index, which tracks the shipping rates for bulk commodities around the world. (See: Key Economic Indicator Hits a 25-year Low.). I can tell you that the rates have continued to fall over the last month. As a matter of fact, the rates being charged shipping bulk commodities now are the same rates charged in 1986!

The Baltic Dry Index indicates clearly that there is a demand issue here…more evidence of an economic slowdown. It is no wonder that the Dow Jones Transportation Index is falling.

Since this move in opposite directions three weeks ago between the Dow Jones Industrial Average and the Dow Jones Transportation Index, it is possible that the Dow Theory is signaling a top in the markets. (However, it is important to note that this trend has only been in place for three weeks.)

I will be following the Dow Theory for my readers closely over the next couple of weeks, as we may have another confirmation of the stock market top I’ve been alluding to in my recent writings. So watch out for that stock market rally; the warnings of the rally getting close to a top are building.

Michael’s Personal Notes:

It’s looking more and more as if 2012 will disappoint and be a year of economic slowdown, not growth.

The largest economies in Asia, India and China continue to exhibit signs their economic slowdown is accelerating. For February, China’s manufacturing index showed contraction for a fourth straight month.

My warning is that if the economic slowdown continues to take hold in Asia, there is no way the U.S. will not become a casualty.

India just reported its latest numbers for industrial production for December 2011. Industrial output climbed only 1.8% year-over-year, dropping off from the 5.9% advance year-over-year in November.

The Bank of India has signaled that the economic slowdown in manufacturing and the other indicators it follows means the bank is now changing its stance from increasing interest rates to lowering interest rates.

The Bank of India now believes gross domestic product (GDP) ill rise only 6.9% (if it reaches that) in 2012 after GDP expanded 8.4% in 2011. The 6.9% GDP growth for 2012, if achieved, would be the slowest rate of growth since 2009.

Japan’s economy shrank twice what was expected in the fourth quarter of 2011; whereas GDP actually fell 0.6%. Granted, Japan still is dealing with rebuilding from the horrible tsunami disaster of last spring, but those within the Bank of Japan acknowledge that the number was worse than expected because of fewer sales to Europe—economic slowdown.

There is a consistent theme with the weaker economic numbers above. All the countries I speak of above were negatively impacted by slowing export sales to Europe, which brought the economic slowdown home to their respective countries.

As the vicious circle of the economic slowdown continues to play itself out, Europe’s economic woes will worsen, which will affect Asia—especially China—and that in turn will bring the economic slowdown home to the U.S.

It is important to note that, as we move forward in 2012, to date, the economic statistics coming from Europe and Asia continue to worsen. This means that the economic slowdown is gaining momentum to the downside.

As a result, when the economic slowdown finally hits the U.S. (and the time is not too far off), the impact will be that much greater. Be careful with that stock market rally, dear reader, the economic slowdown is coming ashore. (Also see: How the Massive Global Economic Slowdown Will Affect Us.)

Where the Market Stands; Where it’s Headed:

Wow! What a run the stock market has had his year. The Dow Jones Industrial Average has gained 813 points in the first two months of 2012; that’s a gain of 6.7% in two months.

I believe that the bear market rally that started in March of 2009 has some leg left to it. Sure, the rally is getting old and tired, but I believe it has further room to move on the upside.

What He Said:

“I see the coming recession being deep and difficult, because U.S. consumers do not have the savings to spend their way out of the recession. The same thing happened in Japan. The Japan example proved that, when consumer confidence is shattered, even zero percent interest won’t spur consumer spending. The same thing could happen here.” Michael Lombardi in PROFIT CONFIDENTIAL, August 23, 2006. Michael started talking about and predicting the financial catastrophe we began experiencing in 2008 long before anyone else.