In A Topping Market, Small Caps Have Diverged From Industrials

03/09/12 08:37:19 AM

by Matt Blackman

In my last article, "Another Sign Of A Market Top?," we saw how the transports had diverged from the industrials, which is a Dow theory warning sign that a reversal may be in the offing. A falling Russell 2000 small-cap index adds more weight to this call.

Security: DIA, IYT, IWM
Position: N/A

In the early stages of a rally, transports and small caps are usually first out of the gate and, in the process, provide a heads-up to the proactive trader know that a new game is on. Larger companies such as those populating the Dow Jones Industrial Average (DJIA) tend to take longer to respond to an improving economic environment so usually turn up well after the small caps.

FIGURE 1: COMPARISONS. Here's a daily chart comparing trendline (green) for the Diamonds Trust ETF (DIA), the blue trendline for the Dow Transports ETF (IYT), and the purple trendline for the iShares Russell 2000 Index ETF (IWM) showing the strong divergence between them since the beginning of February 2012.

Graphic provided by: FreeStockCharts.com.

As we see in Figure 1, this has not been the case in the last month. Both transports and small-cap stocks have been languishing, another sign that all is not well in stock market land. For a rally to be confirmed, the majority of sectors including transports must move together with the industrials. The more responsive small caps should be leading their larger brothers higher.

This bearish view is confirmed over the longer term. As Figure 2 shows, the industrials continued to rally higher after the correction in the summer of 2011, but transports and small caps still haven't recaptured their May 2011 highs. So the divergence exists on both the daily and weekly charts.

FIGURE 2: DIVERGENCE. The divergence also appears on the weekly chart of DIA, IYT, and IWM started July 2011.

Graphic provided by: FreeStockCharts.com.

It is possible that small caps and transports will reenergize and eventually put in higher highs in the coming months. But the probability of this occurring is not high.

Weakness in the transports and small caps is just one more sign that headwinds against the current large-cap rally are growing. Although there is no way of knowing exactly when and how big the coming stock correction will be, this is one of those times to heed the sage advice of philosopher Will Rogers:

"I'm much more concerned with the return of my capital than the return on my capital."

Matt Blackman

Matt Blackman is a full-time technical and financial writer and trader. He produces corporate and financial newsletters, and assists clients in getting published in the mainstream media. He is the host of TradeSystemGuru.com. Matt has earned the Chartered Market Technician (CMT) designation. Find out what stocks and futures Matt is watching on Twitter at www.twitter.com/RatioTrade

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In A Topping Market, Small Caps Have Diverged From Industrials

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