Broader Market And Dow Theory Suggest Proceeding With Caution

Includes: DIA, IYT, SPY
by: New Low Observer

As the Dow Jones Industrial Average (NYSEARCA:DIA) and S&P 500 (NYSEARCA:SPY) exceed the highs set in 2011, there is an alarming coincidence with 1972, just before the Dow Industrial's -44% decline, that we'd like to bring to your attention. To set the stage, we must first point out an important factor about the Dow Industrials and S&P 500 that contributes to their ability to reach new highs.

First, the Dow Jones Industrial Average is what is considered to be a price-weighted index. According to, a price weighted-index is:

"A stock index in which each stock influences the index in proportion to its price per share. The value of the index is generated by adding the prices of each of the stocks in the index and dividing them by the total number of stocks. Stocks with a higher price will be given more weight and, therefore, will have a greater influence over the performance of the index."

Next is the S&P 500. The S&P 500 is a capitalization-weighted index. Again, referring back to, a market-cap weighted index is:

"A type of market index whose individual components are weighted according to their market capitalization, so that larger components carry a larger percentage weighting. The value of a capitalization-weighted index can be computed by adding up the collective market capitalizations of its members and dividing it by the number of securities in the index."

Each of these indexes are biased in the way they reflect the overall market movement. In the case of the Dow Jones Industrial Average, it is biased towards the highest priced members while the S&P 500 is tilted to the stocks that are similarly expensive, on a market-cap basis. In order to get a true sense of how all of the stocks are faring, rather than a select few that have been favored by investors, it is best to track a broadly based "equal-weighted" stock index. According to, an equal-weighted stock index is:

"A type of weighting that gives the same weight, or importance, to each stock in a portfolio or index fund. The smallest companies are given equal weight to the largest companies in an equal-weight index fund or portfolio. This allows all of the companies to be considered on an even playing field."

For the most part, an equal-weighted index reflects how all stocks have fared in a bull or bear market. This is important because it allows for greater insight into where we are and potentially where we might be going. One equal weighted index of over 1,700 companies that has been around since 1962 is the Value Line Geometric Index (found here). In the chart below, we have compared the market action of the Value Line Geometric Index over a ten year period from 1962-1972 and 2002-2012.

(Click to enlarge)

What should stand out the most between both charts is the fact that, according to the Value Line Geometric Index, while the general indexes like the S&P 500 and Dow Jones Industrial Average are making new highs, the majority of stocks have not participated in the rise. In addition to not exceeding the peaks of 1968-1969 and 2007, the inability to exceed the 2011 highs is an indication of significant resistance as was experienced in 1971 and 1972 peaks.

Adding to our concern about the lack of participation by the broader stock market is the divergence between the Dow Jones Transportation Average (NYSEARCA:IYT) and the Dow Jones Industrial Average since February 2012. This divergence can also be found in the chart below in the period from April 6, 1972 to January 5, 1973 between the Transports and Industrials. The declines that followed the divergence and peak of '72-'73 were -59% and -44% for the Transports and Industrials, respectively.

(Click to enlarge)

Until the Dow Theory divergence is resolved and the Value Line Geometric Index make new highs above the 2011 and 2007 peaks, we're concerned that the stock market is skating on thin ice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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