Even those who pay little attention to technical analysis or Dow Theory have been acknowledging the divergence between the Industrials and Transports. This ominous signal has identified major corrections and bear markets in the past, making it worthy of our consideration.
I’ve been trying to understand what’s been driving the malaise in the Transports and while I’ll be the first to admit that I don’t know … there are some interesting dynamics at play.
Looking at some of the anecdotal evidence below has me wondering if it’s possible that the Transports simply got ahead of themselves and are reverting back to trend.
[Read: Ralph Acampora on Why This Market Is Like the 60s]
Let’s begin with this first chart, which shows the price of oil at the top, followed by the Industrials and then the Transports. The vertical blue line denotes the last time the Industrials and Transports confirmed one another.
You’ll notice immediately that this occurred right as oil was approaching its bottom, which at least as of now, has held. This marked a turning point as the Industrials continued their climb upward, while the Transports veered off course.
From the charts above, it appears that the two averages (Industrials and Transports) were tracking each other very well up until the divergence, but a different perspective calls that assumption into question.
Dow Theory defines a bullish confirmation as an occurrence when both the Industrials and Transports reach new highs. What is unspecified is the magnitude of those highs. For example, if the Industrials close at a new high by a point, but the Transports set a new high by 100 points, the two averages are said to have confirmed one another and not much thought is given to the magnitude of the moves upward.
Let’s expand our time horizon and look at a chart that shows the performance of the Industrials, Transports, and oil, on a percentage basis, since the bull market began on March 9, 2009.
Here we can see that the Transports (blue) have been consistently outperforming the Industrials (red) for the duration of this bull market. This relative outperformance continued to expand as the price of oil plummeted, and has only begun to contract since oil found a bottom.
Could it be that the Transports simply ran too far too fast, and the weakness we are seeing is reversion-to-the-mean in nature? A number of factors may support this thesis.
According to the Wall Street Journal Market Data Group, the Industrials are currently trading at a trailing PE of 16.22, while the Transports, even after struggling for the last six months, are at 18.92. Of course, the multiples that investors are willing to pay is a function of many variables, including underlying growth and dividend rates, but this suggests that investors still find significant value in the Transportation Average stocks.
Plummeting oil prices over the last year helped the Transportation sector achieve lofty valuations, especially when calls for - dollar oil were commonplace. Since then, we’ve seen oil prices stabilize, and this has weighed heavily on the sector.
[Read also: OPEC Losing Its Ability to Set Global Oil Prices]
Some of the worst performing stocks in the Transportation Average include airlines such as United Continental, Delta and Southwest. However, according to the International Air Transport Association estimates, the airline industry is on track to post record net income this year, up almost 80% from 2014. The IATA estimates that earnings at North American carriers will account for .7 billion of the total, with margins nearly double that of Europe and Asia. They cite improved demand, evidenced by a record expected seat-occupancy level of 80.2 percent.
This suggests (once again, anecdotally), that the sharp share price declines seen in some of the airlines in the Transportation Average may not be driven by deteriorating fundamentals, but by valuations that soared too high.
Railroads have also been dragging down the Transportation Average, and much of this has to do with coal. According to the U.S. Energy Information Administration, coal exports have fallen as a result of weak fuel prices and soft global demand.
[See: Coal Facing Worst Year Yet in 2015]
The CFO of Union Pacific (down 14.1% YTD) said that coal shipments in the second quarter declined by 25%. They attributed much of the decline to softness in natural-gas prices.
Prior to that, Kansas City Southern (the worst performing component of the Dow Transports, down 22.8% YTD) withdrew its 2015 revenue outlook, citing uncertainty in energy-related markets. They stated that revenues from their energy segment have declined 50% so far in the second quarter of 2015. Could the slump in railroad stocks be primarily a result of energy related disruptions and not necessarily an eminent slowdown in overall commerce?
Circling back to Dow Theory, the divergence between the Transports and Industrials is significant and should put you on alert. But considering the factors above, it seems reasonable to postulate that perhaps the recent downward move in the Transports is partially the result of an average that got ahead of itself, combined with problems symptomatic not of a dying economy, but of disruptions caused by large magnitude shifts in energy markets.
[Listen to: Oil Wars – Game of Thrones – Part II]
Regardless, we will continue to monitor the averages with the acknowledgement that the Transportation Average remains a leading index and could soon be confirmed in direction by the Industrials, resulting in a Dow Theory bearish confirmation. Until then, the benefit of the doubt (at least according to Dow and most practitioners) is given to the last signal, which was bullish.
The preceding content was an excerpt from Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
