Stock Market on the Verge of a New Trend

Stock Market on the Verge of a New TrendThe stock market is on the third leg of a repeating pattern that began about three years ago. The spectacular stock market decline that began in 2008 hit a bottom in March 2009, and then promptly recovered. July 2009 saw a significant recovery in share prices, followed by a rising trend that lasted until April 2010. The pattern then repeated itself the next year and looks to be in the process of repeating a third time.

This stock market action is evident in all the major indices, including the S&P 500 Index, the NASDAQ Composite, and the Dow Jones Industrials. In the 2009 and 2010 price trend, the Dow Jones Transportation Index led the Dow Jones Industrials. Its performance over the Dow Jones Industrials was more pronounced then. But not anymore; the Dow Jones Transportation Index is losing its leadership trend and this, combined with generally low trading volume, leads me to suspect that the stock market is in the process of topping out.

When will the top happen? That’s total guesswork and unanswerable. But there’s a lot of change coming in the world, both politically and financially. Sovereign debt in most of the world’s mature economies (including the U.S.) will have to be addressed in 2013. With higher interest rates, capital markets have already begun to force these economies to address their debt. And the coming austerity measures will put the brakes on growth, because for the most part, government spending is a big part of economic activity.

With this fundamental backdrop, it makes a difficult case for being bullish on the stock market, and perhaps this is why trading volume has been on the decline since 2009. (See “Stock Market Investor Sentiment Drops Again…Why?”) The Dow Jones Industrials have recovered tremendously well since the financial crisis, but it’s certainly clear that individual investors are participating in the stock market to a lesser degree. Institutional investors have been highly conservative with their investing, and this is why so many large-cap, dividend paying stocks are at their highs.

There are always good trades in any market, both speculative and income-providing, but I think it’s time to become highly cautious regarding the stock market. Not that we all weren’t before. This summer’s stealth bull market may very well continue for another few months. But if we don’t get some new upside in the Dow Jones Transportation Index, then it’s going to be very difficult for the rest of the stock market to advance.

Obviously, investors are in wait-and-see mode until next week’s Federal Open Market Committee (FOMC) meeting. The Dow Jones Industrial Average is holding up better than the S&P 500 Index. The NASDAQ Composite has been the star over the last three years. The most likely scenario that I see playing out over the next couple of years is another U.S. recession combined with higher price inflation. Economic stagnation in the eurozone should continue, but China and the rest of Asia will lead a new upward business cycle, which the U.S. will catch up to perhaps in 2014.

If you own dividend paying stocks in the Dow Jones Industrials, I wouldn’t necessarily sell them in anticipation of the next recession. Dividend income is going to be the only friend an investor has over the next couple of years. The performance of the Dow Jones Transportation Index and low trading volume worries me. And it isn’t the price of oil that’s causing this index to lag, it’s something else.