Market Insider

Dow Transports Fall Hard—A Sign Market Rally Could Be Cracking

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The sharp selloff in the Dow Transportation index this week is causing some strategists to wonder if the market may finally see its long-awaited pullback.

The Transportation index—which led the market higher in the last few months—surged 13 percent for the first quarter, while the Dow Jones climbed 11 percent in the same period. The Transports, considered by some to be an economic bellwether are up 22 percent since the market rally began in November, while the Dow is up 16 percent and the S&P 500 is up 14.8 percent.

But this week, the Dow Transports declined more than 1 percent each day and broke below the 50-day moving average in a third day of selling Wednesday. The last time the index dropped 1 percent or more a day, in a three day period, was back in July.

By Wednesday, the broader stock market joined the sell off, logging its worst one-day performance in over a month. The losses came a day after the Dow and S&P 500 both closed at record highs.

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Rally Warning Signs?

The initial divergence in the indexes earlier this week was a red flag for traders, who also were watching an outsized drop in the small cap Russell 2000 index. The Russell is down 3.5 percent for the week so far. The Dow Transports are down nearly 4 percent, while the Dow is down just 0.2 percent and the S&P 500 is off nearly 1 percent.

For Dow Theory enthusiasts, the Dow Jones Industrial Average and the Dow Jones Transportation index need to move in lockstep to reach new highs or lows. A separation implies that the market will decline to its former trading range.

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"Given the fact that the small caps and transports have played a major role in the advance of this rally over the last few months, this is something to watch and could represent a potential turning point or lead to some churning in the days ahead," said Michael Sheldon, chief market strategist at RDM Financial Group.

But with the growing number of traders and strategists expecting a market pullback on the heels of the robust first-quarter rally, the latest action in small caps and transports have some wondering if the steepness of the declines could be signs that cracks are forming in the recent rally.

"Trying to predict when the market is going to pullback is hard…but the market has had a significant advance so it would only be natural and healthy to digest some of the gains as investors look for the next catalyst," said Sheldon.

Meanwhile, some experts downplayed the concerns, saying history shows the divergence doesn't always lead to a longer-term downtrend.

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Looking at small caps, for instance, there have been only five other two-day periods in the last decade where the S&P 500 traded up while at the same time, the Russell 2000 traded down more than 1.5 percent. And according to Bespoke Investment Group, the S&P 500 has been up an average of nearly 5.5 percent in the following month. Similarly, the Russell 2000 also saw remarkable gains with an average return of more than 8 percent.

"While there has been a lot of angst over the recent underperformance of small caps, based on the historical record, these periods have typically not been a sign of the beginning of a longer-term downtrend for small caps or the overall market," according to a note from Bespoke.

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—By CNBC's JeeYeon Park (Follow JeeYeon on Twitter: @JeeYeonParkCNBC)

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