A FEW CRACKS ARE SHOWING IN THE STOCK UPTREND -- THE FIRST ONE IS DOW OUTPERFORMANCE -- THE SECOND IS TRANSPORTATION SELLING -- A THIRD IS SMALL CAP WEAKNESS -- AND STOCKS HAVE ENTERED A SEASONALLY A WEAK PERIOD BEWEEN AUGUST AND SEPTEMBER

DOW OUTPERFORMANCE MAY NOT BE A SIGN OF MARKET STRENGTH... It seems everyone in the media has been transfixed on the Dow Industrials hitting 22K this week. And they cite that as proof that the stock rally is alive and well. That recent Dow strength, however, is coming from a handful of high-priced stocks. [Since the Dow is a price-weighted index, the highest priced stocks carry the most weight]. The first is Boeing which has gained 20% over the last month; Verizon's nearly 10% gain over the last week; and Apple's nearly 5% gain today. While that's good for the Dow, history suggests it's not necessarily good for the rest of the market. That's because Dow leaderhship has usually been more a sign of caution than confidence. The Dow Jones Industrial Average is composed of thirty of the bluest of blue chip stocks. That's where investors go when they're looking for more safety. They buy lesser quality stocks when they're more optimistic. Right now, they're favoring the blue chips. The chart below shows that Dow leadership hasn't been good for the rest of the market over the last decade.

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Chart 1

DOW LEADERSHIP HAS USUALLY ACCOMPANIED MARKET WEAKNESS... The solid line in Chart 1 plots a "relative strength ratio" of the Dow Industrials divided by the S&P 500 over the last ten years. The solid gray area shows the trend of the S&P 500 by itself. Notice first the sharp jump in the ratio in 2008 during the financial crisis, as the Dow outperformed. The ratio peaked at the end of 2008 as that bear market neared completion and a new bull market started in the spring of 2009. The ratio fell for most of the time since then, as the Dow underperformed and the market rose. The next blip in the ratio took place during 2011 when the S&P 500 lost nearly 20% (first circle). There again, Dow leadership coincided with market weakness. The same thing happened during 2015 (second circle). Interestingly, the Dow/SPX ratio bottomed that August as the market weakened. After pulling back in early 2016 as the market turned up, the ratio turned higher later that year and is now at the highest level in three years. I take that as a possible sign of "late cycle" behavior as the aging bull market enters its ninth year. Chart 1 shows Dow leadership usually coinciding with periods of market weakness, not strength. Chart 2 shows that Dow leadership sometimes precedes a market top.

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Chart 2

A TWO-DECADE LOOK AT DOW LEADERSHIP... Chart 2 (above) plots the same chart over the last two decades. But the message is the same. The Dow/SPX ratio surged during the bear market between 2000 and 2002. It peaked in 2003 as the market bottomed and continued to drop for the next three years. It started rising again in 2006 and rose throughout 2007, just prior to the financial crisis (and rose during 2008). Its next major peak took pace as the last bull market started in early 2009. The Dow/SPX ratio bottomed in the middle of 2015 (during a market downturn) and has been rising for the last two years. If the history of the past two decades is any guide, that's a not necessarily a positive sign for the market.

DOW TRANSPORTS ARE WEAKENING... Here's another potential problem for the Dow Industrials. While they're hitting new highs, the Dow Transports are falling. The daily bars in Chart 3 show the Dow Transports tumbling nearly -5% over the last month. In addition, the transports are threatening their 200-day average. They bounced off that major support line during May. Let's hope they do so again. Dow Theorists like to compare the trend of the Dow Tranports with the Industrials because the market is usually stronger when both are rising together. Right now, they're not. The solid line on top of Chart 3 shows the transports underperforming the industrials by a wide margin this year. That relative strength line has reached an important testing point. Chart 4 shows the ratio peaking in 2015 and now trading near its 2016 low. Any further weakness could push it to the lowest level in nearly five years. That might start to cause some problems for the Dow Industrials.

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Chart 3

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Chart 4

SMALL CAPS ARE ALSO WEAKENING... Another potential problem may be coming from signs of weakness in small cap stocks. Chart 5 shows the Russell 2000 Small Cap Index in danger of falling below its 50-day average. The top line in Chart 5 show the RUT/SPX ratio in danger of falling to a new low for the year. A weak dollar has benefitted large cap stocks this year which get nearly half of their revenues from foreign markets. That didn't prevent the Russell 2000 Index from hitting a record high last month. A downturn here, however, could put some additional pressure on the S&P 500 which is in a short-term overbought condition. Stocks look vulnerable to some profit-taking at current levels. Even the Nasdaq is losing ground today as technology stocks continue to weaken (in the face of stronger earnings from Apple). And there's one more thing.

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Chart 5

STOCKS HAVE ENTERED A WEAK SEASONAL PERIOD ... After a normal July bounce, stocks have now entered the seasonally weak period between August and September. In fact, they're usually the two weakest months of the year. Given some of the warning signals mentioned above, combined with short-term overbought readings, some profit-taking wouldn't be surprising.