Is the Dow Jones Industrial Average Topping Out?

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With the decline in stocks this week, it appears as if the Dow Jones Industrial Average has completed a double top formation. This means that the Dow hit a certain point during its ascent, then corrected, then rose again, but failed to rise above the first peak. The implication from a technical standpoint is that investors are intent on selling at that level, and that new buying has abated so that it is not sufficient enough to drive prices higher. This is bearish, and it suggests to me that we may be seeing a top in the Dow and in stocks more generally.

There are many other signals that this is the case as well. First, we are seeing declines in economically sensitive assets, most notably base metals such as copper. Copper, sometimes referred to as “Dr. Copper,” is used in industrial goods ubiquitously, and a decline in copper prices signals a decline in demand for industrial goods. While copper has risen in the last few trading sessions, it has failed to breach the psychologically important level of $3 per pound, and it looks like it is going to break lower.

Second, we are seeing the shares of riskier companies, notably those in the Nasdaq 100, sell off more aggressively than shares of other large-cap companies. While the Nasdaq 100, unlike the Dow, made a new high after its January high, it has been selling off more aggressively. Over the past month, the Dow is flat, but the Nasdaq 100 is down nearly 4 percent.

When investors get nervous they tend to sell riskier stocks, especially if they have gains in these stocks, in order to raise cash or to buy shares in more defensive companies. Stocks such as Amazon (NASDAQ:AMZN) and Netflix (NASDAQ:NFLX), Priceline (NASDAQ:PCLN), and Starbucks (NASDAQ:SBUX) are selling off more than the rest of the market. These are high-growth stocks that have been outperforming the market. If these start to sell off, then it stands to follow that investors are becoming nervous about stocks more generally, and we could begin to see a broader selloff begin.

Third, if we look at a couple of individual Dow components, we see topping patterns in several bellwether names that heavily influence the index. Before explain this point, I should note that unlike other indexes, the Dow weights stocks by their stock prices. So even though Exxon Mobile (NYSE:XOM) is the most valuable company in the index, companies such as Chevron (NYSE:CVX) and IBM (NYSE:IBM) have heavier weightings. A couple of these stocks look like they are topping out.

IBM has been in a topping out pattern for years. The company has seen its revenues decline for two consecutive years, although management has been able to keep up appearances by buying back stock and cutting costs so that profits and earnings per share have continued to be strong. While the stock tried to break out earlier in the month, it failed to do so and fell back below the $190 level.

Visa (NYSE:V), which has the highest weighting of any Dow stock, also appears to be topping out. Investors have been relentlessly bidding up shares of Visa, given their confidence in the company’s dominant position in the cashless payments market. This reached a point of over-exuberance, and a correction is to be expected.

These two stocks alone comprise 16 percent of the Dow, and a correction in their share prices will have significant consequences if they drag the Dow lower. If the Dow falls, investors will look at this and assume that it is a signal that stocks more broadly are falling, and this could create selling in other names.

Ultimately, there are several ominous signs that indicate that we could be nearing a bear market. Investors should take caution and either sell some stock or hold off on buying more stock until we reach a better entry point. Note that I am not suggesting that investors do anything impulsive, but if you have profits, take something off.

More aggressive investors should consider taking a short position. Investors looking to short the Dow should consider the Proshares Short Dow 30 ETF (DOG). This ETF is designed to track the daily inverse performance of the Dow. Note that this fund “resets” every day, and buying DOG shares is not exactly the same thing as shorting the Dow. To explain this, I will employ the following example: Suppose the DOG starts at $100 per share, and the Dow rises 10 percent in one day. DOG falls to $90 per share.

Now suppose that on the next day the Dow falls 10 percent, which means that it is trading at 99 percent of its original value. DOG rises 10 percent on the second day, which means that it is trading at $99 per share. In other words, you were right that the Dow would fall, but you still lost money on your bet. While the fund should generally be negatively correlated to the Dow, this negative correlation will be imperfect and it will get worse with time, so be careful!

Disclosure: Ben Kramer-Miller is long Visa, Exxon Mobile, and Chevron.

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