Two Steps Back

Market Moves 

For the major U.S. large-cap indexes, Wednesday marked the second consecutive down day since Monday's across-the-board record highs. And trading activity toward the close of the trading day on Wednesday showed a flurry of selling activity, prompting a close at or very near the lows of the day. Clearly, this does not bode well for market sentiment going into Thursday.

But while the two-day pullback has been significant, it currently represents only a very small stumble within the context of a robust bull market just off all-time highs. At least for now. That said, we'll analyze some risk elements in this bull market's structure using chart comparisons below.

Driving the continued market sell-off on Wednesday were lingering concerns about a stalled U.S.-China trade agreement as well as caution amid the first week of earnings season. So far, the vast majority of earnings reports have been better than expected. But that's likely just a result of lowered expectations due to the projected impact of slowing economic growth and trade wars. As more companies report earnings in the days and weeks ahead, the trend of earnings beats will need to continue in order to keep stocks afloat.

The chart below shows the Dow Jones Industrial Average daily chart going back to 2018. The two-day pullback (so far) is on the far right. The line-in-the-sand support level for the Dow is around 26,950. If the index remains above that support area, which represents the prior resistance highs, any rebound is likely to prompt a further move into new record territory. But any move back below that price region would signify a failed upside breakout.

Chart showing the performance of the Dow Jones Industrial Average

Dow Theory Unfulfilled

Dow theory forms one of the cornerstones of technical analysis. Though the theory was formulated by Charles Dow (who helped found Dow Jones & Company) all the way back in the late 1800s, it is still widely followed by analysts and traders to this day.

Among the major tenets of this theory is that the Dow Jones Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA) must confirm each other. More specifically, the two averages should make new highs at or around the same time in order to establish a market-wide bull market.

As shown on the comparison chart of the two averages, the DJIA (in green) just made a new all-time closing high on Monday. But this is far from the case for the DJTA (in orange), which has not even come close to approaching its own late-April high. In fact, after Wednesday's sharp dive for the transportation average, it's more than 6% below that high. What does this signify about the current market? If you subscribe to Dow theory, we just don't have a true bull market, yet.

Chart showing the performance of the Dow Jones Industrial Average and Dow Jones Transportation Average

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Small Caps Lead Pullback

Another chart comparison is also questioning the integrity of the current bull market – large caps vs. small caps. The chart shows the year-to-date price action for both the S&P 500, representing the large caps, and the Russell 2000, representing the small caps.

Small caps led the decline on Wednesday. But more than that, they have lagged the large caps considerably since late last year. The Russell 2000 is now more than 11% below its record high from last August. In contrast, the large-cap indexes are currently just off new all-time highs.

This is a potential warning signal for the entire market, as small caps are often seen as a leading indicator for the rest of the market.

Chart showing the performance of the Russell 2000 Index

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The Bottom Line

The second negative day after record highs should not be of major concern to the markets, especially amid mostly better-than-expected earnings results. It's been a shallow pullback thus far, but a significantly larger stumble could be worrisome, particularly given some warning signs in the market structure when viewed from a technical perspective. Stocks generally remain well supported for the time being, but any breach of key support levels could result in a deterioration of recent bullish momentum.

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