Tom Essaye: There’s no question that the rally we’ve seen in markets up to this point in the year has been impressive. Through the end of last week, the S&P 500 (NYSEArca:SPY) was up almost 9 percent and we’re not even through two full months of 2012!
The rally has been fueled by ultra-accommodative measures taken by the world’s central banks along with better than expected economic numbers here in the U.S. and in Europe.
Surprisingly, given the rough year of 2011, I almost sense some complacency in the markets, as evidenced by recent consumer confidence numbers hitting one-year highs, and a Barron’s cover calling for Dow 15,000.
Savvy contrarian investors, however, know to look beyond the headlines and past the major averages for clues as to the market’s next moves.
And when we look past the impressive performance of the S&P year to date, we can see some leading indicators that warrant a level of concern …
The first is the Dow Transportation Index (NYSEArca:IYT). This index tends to rally before the rest of the market turns up, and it falls before a general market decline.
The reason for this is quite logical: The Dow Transports, as they are known on the Street, is made up of companies like Fed Ex (NYSE:FDX), UPS (NYSE:UPS), and others that are on the leading edge of the economy. When the economy is growing, their stocks do very well because businesses are shipping goods around the world. And when the economy is contracting, these companies are the first to feel it.
It’s a bit concerning then that the Dow Transportation Index did not confirm the new high we saw in the general market a little over a week ago. This divergence between the two indices has historically been a warning sign that the market may not be as healthy as everyone thinks.
The second leading indicator is the small cap sector. The Russell 2000 (NYSEArca:IWM) has also shown some relative weakness here, stalling while the larger cap indices like the Dow and S&P have made new highs. You can easily see the divergence in the chart below.
Small cap companies, like the transportation sector, are very economically sensitive. And they can fall, or pause first, before the rest of the market heads south.
Professional traders often look at the “internals” of a market, not just the bigger averages, for clues into the future direction. And these two internal indicators are throwing up a caution flag.
But just because the market seems poised to take a header doesn’t mean you have to sit on the sidelines and watch the life getting sucked out of your portfolio …
Inverse ETFs with exposure to these leading sectors of the economy, such as the ProShares Ultra Short Russell 2000 Growth ETF (NYSEArca:SKK), can be a good hedge to existing long positions you may have. Or you could consider them as investments to profit from a correction.
Another idea is investments that are out of favor, or that the crowd hasn’t caught wind of yet. In fact I just put together a proprietary report on contrarian investments that were never meant to be sold to the public! You can read about them right here.
Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Nilus Mattive, Claus Vogt, Ron Rowland, and Michael Larson. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Andrea Baumwald, John Burke, Marci Campbell, Selene Ceballo, Amber Dakar, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.
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