Dow Jones Industrial Average: This Little-Known Indicator Says Stocks Are About To Tumble

market correction bearDouglas Davenport: U.S. equities have defied their usual seasonal weakness this summer.

The Dow Jones Industrial Average (INDEXDJX:.DJI) and S&P 500 (INDEXSP:.INX) recently rose to all-time highs. But now, investors are beginning to question whether this is still a healthy bull market with more room to run, or whether it’s on its last legs.

A technical indicator I consult daily may have the answer. It’s called the NYSE McClellan Oscillator (symbol: $NYMO). This so-called breadth indicator measures the difference between the number of advancing and declining shares on the New York Stock Exchange to determine whether the market is overbought or oversold.

A technical indicator I consult daily is waving a red flag for stock-market bulls.
A technical indicator I consult daily is waving a red flag for stock-market bulls.

Anything under minus-40 (see chart below) indicates that stocks are oversold, and the market is bottoming. Conversely, when the McClellan Oscillator breaks through plus-40, it is an indication that stocks are overbought and a market top may be nearing.

Timing the Market

Typically, the NYSE McClellan Oscillator and stock prices have a high positive correlation. In other words, the indicator’s peak and trough signals tend to occur in concert with the broad indexes, give or take a few days. So, historically, when the Oscillator breaches minus-40 to the down side, we can expect stocks to bottom and soon begin to head higher. And when it rises past plus-40, the smart money bets that a new downtrend will begin shortly.

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Still, the relationship between the McClellan Oscillator and major U.S. stock indexes broke down earlier this year. In early May, the indicator topped plus-40, signaling that stocks were overbought. But the S&P 500 continued to rise for another three weeks — and nearly 50 points!

As you can see from the chart, we’re facing similar conditions now. The McClellan Oscillator surged past

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