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Here's why Dow theory is flashing a warning sign for stocks

Yahoo Finance’s Jared Blikre breaks down Tuesday’s market action.

Video Transcript

MYLES UDLAND: Hi, welcome back to "Yahoo Finance Live" on this Tuesday morning. Jared Blikre safely back from the floor of the New York Stock Exchange, joining us now for a look inside the markets internals here. And Jared, I want to talk a little bit about Dow theory and what that is telling us about the setup here for markets. We talked at length this morning about the setup in crypto markets. Equity markets, though, maybe looking quite a bit more constructive.

JARED BLIKRE: They are. And let's go-- let's dial this back and get real basic here, because I'm excited to talk about this. It all gets down to market sentiment, and what we're looking at now is the Dow industrials versus the Dow transport. These are the most ancient indices. And when you use them together, and you can use them together to kind of confirm the price movement, and so if you see a record high in one index, you want to see a record high or a significant high in the other to confirm it. And when you see a trend change in one, you also want to see a trend change in the other to confirm it.

And when one gets a trend change, you're probably going to get a trend change in the other. So this was a very primitive tool, but a powerful tool back in the day. Today, now we have other, I guess, other measures of market internals. We have a number of stocks that are above the 52-week-- or hitting new 52-week highs above their 50-day average, above their 200-day average, and such. So let me break down this chart, because it gets down to trend.

First, this is the year to date, so we have-- the definition of a trend is higher highs and higher lows. So let's take the transports. We have a low here, we have a high here. Higher low, higher high. Higher low. This goes on, and this goes on until, guess what, we have this low here but then we break it. And then we have a lower high and a lower low. So we have a trend change. And guess what? The same thing is happening in the Dow industrials.

We have these series of higher highs and higher lows throughout into May, and then the trend changes. So this is just a very old and simple way of measuring market sentiment. And if these two indexes are both trending lower, well, that's what the trend is. Now, I want to go back. And I'm going to show us the S&P 500. Actually, let's stick with the Dow here. I'll do a three-month chart of the Dow. And you can see, we're climbing up here.

Here is another method of technical analysis. We take this high here, we take this low here, and we measure the 50% retracement, also called the halfway back. And this comes to about 34,200. And there are some other technical levels that are-- other technical reasons why this is an important level. We haven't hit the all-clear. In fact, we're not even that close to it. We really need to rise up and see if there's participation.

Participation means, does the level get some price reaction. If it goes down, then we have price participation from that level. If it price just blows through the level, then you don't have participation and it's not that meaningful. So price always tells us what the market participants are doing. You just have to learn to read it. And it takes some time and practice, but it's very, very useful and it saves a lot of headache and money, guys.

- Jared, you know, we were talking about this briefly, the email yesterday, and you find other internals of the market that are also starting to break down. What are some of the most worrisome on your radar?

JARED BLIKRE: Well, I like to look at the trend in new 52-week highs, and not only all the stocks that are listed on the New York Stock Exchange but also the S&P 500. I don't have the charts here at my disposal to show you, but, you know, it's another form of market sentiment. So if you have the market going higher but the number of stocks that are hitting one-month lows is increasing, that means that the market is fueling a rally based on a few concentrated stocks, and that's what we have when we have these big growth, these mega cap names, fueling the higher highs in the indices.

It's not that sustainable. You want to see participation. You want to see other sectors rallying to new highs as well. So if you see all of that-- if you see all of that, then you have confirmation. But when you have divergences-- and that's what we're looking for. Divergences are an indication of when there's a little bit of disagreement in the market. It's not showing up in the majors, but it's under the hood. So using all this information together, you can get an idea of when things are starting to break down.

There are always a lot of clues. And if you just pay attention, and keep an open mind, and release yourself from your opinions, then you can see these things and hopefully not lose your shirt and live to trade another day.

MYLES UDLAND: All right. Jared Blikre with a look at the set up right now inside the market pass, some of those headline indice price levels we talk about so often here on "Yahoo Finance."