Did This Weird Ratio Signal The Top?

Correlations are not causation but they can be helpful in spotting weird patterns that reveal where the market may be heading next. One such correlation pattern that has surfaced recently is that of the ratio between the DIA and QQQ.

One trader spotted that when the ratio, DIA/QQQ, hits a low, it has often preceded a correction in the QQQs. Specifically, he identified that the ratio bottomed during the dot com bubble, which marked the top in the NASDAQ.

Then in the 2021-22 period, the DIA/QQQ bottom preceded the NASDAQ top once again. So where does this ratio sit now?

Key Points

• While correlations in the market are not evidence of causation, they can reveal unusual patterns that often repeat.
• One interesting ratio now, the DIA/QQQ, is bottoming as it did during the dot com bubble and in 2021-22.
• Both times it bottomed previously, it preceded the peak in the NASDAQ.

The Nostradamus Ratio

While no indicator is perfect all of the time, the Dow Jones to NASDAQ ratio has a pretty good track record of foreshadowing market declines in the more volatile, tech-laden index.

Right now it’s eerily bottoming once again, just as it did a couple of years ago. Remarkably, when it bottomed then it was the first time in a few decades to do so, yet here we are again just a couple of years later once again seeing evidence of this indicator hitting its lows.

Credit: eliant_capital

How To Trade This Weird Signal

While no indicator is perfect all of the time, this one is certainly worth paying close attention to. If it’s right the way to trade it is not necessarily to go short the QQQs or the long the DIA but rather to do both simultaneously as part of a pairs trade.

If the QQQs were to fall, that side of the trade, the short position, is likely to be more profitable than the losses accumulated from the DIA also falling and hurting the long DIA position.

Conversely, if the QQQs continue to rise, the expectation is that they will soon begin to underperform on the upside relative to the time-tested old stalwarts in the Dow Jones Industrial Average.

Will the market once again reveal that this ratio has a predictive quality? The next few months will look obvious in hindsight.