History suggests stocks are due for a pause as market soars

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The Dow Jones Industrial Average (^DJI), Nasdaq 100 (^NDX), and S&P 500 (^GSPC) all notched record highs on Wednesday. The latter, the world’s benchmark stock index, also came tantalizingly close to hitting the big, psychological 5,000 level for the first time.

Meanwhile, stocks are now in one of the seasonally weakest months of the year, with an even weaker month ahead often seen in election years. We’re also sitting on a monster three-month rally that history suggests might take a few weeks to digest.

While no one is suggesting investors should tear off their “S&P 5,000” hats and short Nvidia (NVDA), it’s a good time to take stock of what’s been working this year and of some of the increasing divergences that might need correcting.

Classic Dow Theory posits that the Dow Jones Industrial Average and the Dow Jones Transportation Average (^DJT) should agree with each other. In general, there should be broad, directional agreement between the companies that make the stuff and the companies that ship the stuff.

Recently, the industrials have been hitting record highs while the transports have been struggling to break through prior resistance. While this could be resolved by the transports surging higher, seasonals suggest that industrials might “catch down” to the transports.

Then there are the megacaps. Whether it’s the Mag 7, Mag 6, or Mag 4, the subject of market concentration has been talked to death as narrow leadership has gripped the minds of stock market bulls and bears alike.

We can see this in the ratio between two different ways of calculating the S&P 500 — by the usual method of market capitalization, and also by equal weight, wherein each stock has an equivalent weighting in the index.

S&P 500 Market Cap Weighted vs. Equal Weighted

S&P 500 Market Cap Weighted vs. Equal Weighted

The above chart shows that large caps dominated early in the pandemic in 2020, but were taking a back seat to the rest of the market by the presidential election that year. That trend roughly continued until the internet-bank panic of 2023 led to another run of megacap outperformance.

Chartists and fans of technical analysis might see a giant cup-and-handle pattern that points to substantial upside on a definitive break. But, not to get too far ahead, right now and here would be a logical place for the markets to find equilibrium, if only temporarily.

The bullish view is that the soldiers catch up to the megacap generals once again. The bearish view is that the generals will realize they’ve gone too far and need to ride back to the rest of the market.

Either way, there ought to be an opportunity for underrepresented sectors and industries to see more light. In that regard, healthcare, financials, and industrials all broke to new recent highs after some consolidation in the months of December and January.

Large-cap Healthcare (XLV) is the third-best-performing sector this year and is up 17% from the late-October lows. It broke to record highs only recently, but more importantly, it resolved a multiweek consolidation to the upside as it did so. A simple measured move points to an interim $165 target — about 15% above Wednesday’s closing price.

Similarly, large-cap industrials are making record highs again after a six-week consolidation that just retested a prior breakout level. The sector is up 21% from the October lows and is up 2.5% this year.

Finally, large-cap financials might not be making record highs, but similar to industrials, they just retested old resistance, which has now become support. The Financial Select Sector ETF (XLF) is up 24% from the October lows (only behind tech and communication services), and has posted gains of 4% this year.

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