File 2011/Agence France-Presse
The Wall Street sign near the front of the New York Stock Exchange
Something a little worrisome occurred in the stock market a few weeks ago, and at the very least it’s a warning flag that bears watching.
As the Dow Jones industrial average hit new highs on May 18 and 19, the Dow Jones transportation average dropped that same week and hit a seven-month low. That’s worrisome because market technicians monitor the transports — airlines, railroads, airfreight and trucking — for clues to the direction of the economy and stock market.
In fact, a trading strategy, which has been around more than 100 years, developed around the transports called Dow theory. Its origins were a series of editorials written by Charles Dow from 1899 to 1902 and published in The Wall Street Journal.
The basic idea is that the stock prices of the makers of products — industrials — should move in the same direction as the transporters of those products. This is called confirmation. Market technicians who use this strategy will have more confidence in market direction when both the Dow industrials and Dow transports move in lockstep.
Without that confirmation, they have less confidence in their prognostications. That’s why the mid-May sell-off in transports evoked such a stir in the financial press. The current bull market celebrated its sixth anniversary in March, and yet the transports are refusing to confirm that direction, signaling the economy and the stock market might be heading for a fall.
“What we have right now is divergence or a split decision,” said Richard Moroney, editor of Dow Theory Forecasts and, not surprisingly, an expert on Dow theory. “The industrials went to new highs last month while the transports reached significant lows.”
Since the Dow industrials hit that all-time high of 18,312.39 on May 19, it has dropped about 2.3 percent. So market experts are closely watching this downward drift to determine if the bearish trend in transports will be confirmed by a bearish trend in the industrials.
If it is, that is fairly strong evidence that a market change is coming, and it won’t be pretty.
This is a little technical, but a bearish confirmation would come if the Dow drops below 17,164.95 — its most recent low hit on Jan. 30. That would be a drop of more than 4 percent from the Dow’s close Friday of 17,898.84.
“We could get that much of a drop in a couple days with a little bad news,” Moroney said.
There’s merit to the notion that the transports are a reliable window into where the economy and the stock market are heading. When the economy is healthy, businesses and consumers spend more. This means an increased amount of products has to be shipped by rail, truck or air, and the companies providing those services should benefit.
Conversely, when the economy struggles, consumers spend less, demand for products declines and the amount of goods shipped drops. That obviously is a headwind for the stock prices of transportation companies.
“It’s tough to make money in stocks when the most cyclical components [transports] are deteriorating,” Moroney said.
After the 20-stock Dow transportation average hit an all-time high of 9,217.44 on Dec. 29, 2014, it began to break down in late March, and the sell-off has continued into June. The index is down almost 10 percent from its December high, and the losses for some companies are much higher.
For example, shares of Kansas City Southern, a railroad company, are down 22 percent so far this year, while shares of American Airlines Group Inc. are off 24.6 percent. While the sell-off in the transports is troubling, Moroney said the downturn should be kept in perspective.
The transports have been one of this bull market’s best performers, up 294 percent since the bear market low of March 2009. This compares with a 214 percent gain in the Standard & Poor’s 500 Index. In other words, a pullback after such a big gain is not unexpected.
Airline stocks spiked dramatically higher in late 2014 as crude oil prices dropped, lowering their fuel costs. As crude oil has rebounded, airline profits have suffered.
Moroney said one issue affecting the rails might be temporary. Extremely low natural gas prices have pushed utility companies toward burning gas instead of coal. This has reduced the amount of coal shipped by rail, but that could change quickly if natural gas prices rebound.
In any case, it’s premature for investors to start jettisoning stocks out of fear of a bear market. The old warhorse — the Dow Jones industrial average — has yet to confirm the bearish trend of the transports.
“This is just a yellow flag at this point, something to watch,” Moroney said.