Is This Bull Market a Sucker’s Rally?

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The other night, my son and I were watching Now You See Me 2 — and it was fun to watch.

If you haven’t seen the movie, it’s about a secret group of magicians who set out to expose some rather wretched people.

But the best part of the movie is trying to keep up with what’s actually going on, who’s deceiving whom with magic tricks, which character is really in control and how the movie will ultimately end.

Plot twists keep you thinking throughout the movie, but if you miss just one sleight-of-hand trick, you may miss the grand finale altogether — or at least not understand it.

Major trends in the stock market work much the same way.

Right now, the markets are roaring higher. All three major indexes — the Dow Jones Industrial Average, the S&P 500 and the Nasdaq — are hitting all-time highs.

Now, this could easily turn into the next big market rally … or it could end up as a sucker’s rally right before a market collapse.

So which is it?

Well, there are moving parts behind the scenes that I watch to help me grasp market direction, and there is one major market index in particular I will be watching closely in the weeks ahead — the Dow Jones Transportation Average.

A Divergence in the Dow?

A phenomenon I have written about before is the Dow Theory, which states that the Dow Jones Industrial Average and the Dow Jones Transportation Average will both move in the same direction. When they diverge, as they do now, it hints at a coming trend change — in this case, a change to a bear market from a bull market.

While the Dow Jones Industrial Average has set a new all-time high, and thus hit a new higher low and higher high, it is clearly trending higher … which is a good sign. However, activity in the Dow Jones Transportation Average gives me pause. Take a look:

As you can see, the Dow Jones Transportation Average has enjoyed a significant run since bottoming earlier this year, rallying from about 6,500 to roughly 9,000. What it has failed to do, however, is climb to a new higher high, which would necessitate a move above 9,220.

It’s really close, but that level is key.

If the transportation average can close above that level and hold its ground, I’m inclined to expect a continued bull market.

If the average can’t muster enough momentum to close above 9,220, I would expect a retest of this year’s lows — about a 27% decline from current levels.

At that point, it will be a matter of which will converge to the other. Will the transportation average crest new highs, or will the Dow Jones Industrial Average retreat and head lower?

Watch for Market “Tells”

The only thing that you can be certain of is that one will ultimately conform to the other. Either the Dow Jones Transportation Average will continue to rally, or the Dow Jones Industrial Average will pull back.

It will take some time to work itself out — I have been following Dow Theory closely for about a year now. But in the end, it’s “tells” like these that you have to watch to participate in the next major bull or bear market.

Sure, by being patient you might miss out on the first 10% or so of the initial move, but when you are talking about a stock market crash that could be more than 50%, or a rally that could be in the triple digits, missing the first 10% is worth it to be on the right side of the trend.

That’s why as the markets continue to gyrate, and as things happen here and there to distract you from what’s important, don’t forget about the big picture in market trends — they will tell you where the next market move is heading.

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