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Dow Theory Sending 'Troubling Sign' for Stock Rally

Transportation stocks are sending a troubling signal — for Dow theorists in particular — that the four-month market rally is nearing its end.

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In particular, the Dow transport index , which is considered a key confirmation point in Dow Theory, has rolled over in February and reached a triple-topthat could signal an extended selloff is in the making.

Higher energy prices have pressured the transports, which had fallen 3.7 percent since Feb. 3 before rallying Thursday.

"It's a troubling sign, but it's no surprise," says Todd Schoenberger, managing director at LandColt Trading in Lewes, Del. "If you want the one catalyst that is preventing transports from moving in tandem with the industrial average, it's got to be higher oil prices."

Indeed, the fall in transport stocks has nearly mirrored the rise in crude oil prices over the past two weeks. Increasing tensions in Iranhave put a jolt of fear back in the market and threaten the gradual recovery the U.S. economy has seen.

"Our view for 2012 is that energy would be caught in a tug-of-war where it would be supported by Mideast fear and somewhat depressed by the euro zone problems," says Walter Zimmerman, senior technical analyst at United-ICAP in Jersey City, N.J. "It appears that Mideast fears are winning that tug-of-war."

Dow Theory is more than 100 years old but still has many adherents in the financial markets.

In essence, it holds to six principle tenets, with perhaps the two most closely followed being that trends must be confirmed both by internal Dow indexes — particularly the transports as a gauge of shipping activity — as well as trading volume. Market participation has been well below historical norms since the market began rallying in October.

The transports have hit what technicians call a triple-top, meaning it has tested its current level three times over a defined period. They have not fared well in the previous two tests.

The index crossed this range first back in May 2008 before beginning a descent that would last until March 2009. After a strong recovery, the transports made another run at the 5400-5500 range in July 2011 before faltering again.

Both moves mirrored broader market behavior.

Zimmerman believes a similar pattern is possible this time thanks to a strongly overbought market and peaking levels of investor enthusiasm.

"With these overcooked extremes, we're more inclined to think it's going to fail again," he says. "That combination of deeply overbought (stocks) and historic bullish sentiment extremes has been toxic to bull market prospects."

Even Standard & Poor's, which holds a modestly bullish 12-month target of 1400 for the S&P 500 — a 4 percent gain from here — noted that the transport index "has quietly rolled over" and could be indicating trouble.

"We've seen some deterioration in some of the cyclical sectors," says Mark Arbeter, S&P's chief technical strategist. "Certainly one of them has been the transportation average, which has been putting in lower highs and lower lows."

Arbeter is looking for a 3 percent to 5 percent pullback over the next month, followed by a rally that could go as high as 1440 in the S&P 500 "before we see a real decent-size correction."

In the meantime, low trader interestplus the movement in transports has some traders on edge.

"The feeling is if you did not sell into the rally in January you might be lost for the year," LandColt's Schoenberger says. "You have so many headwinds that are preventing any type of robust rally in 2012 that the margin for error is so thin."

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