While the Dow Jones Industrial Average reached a new rally high in June the Dow Jones Transportation Average did not, with many technicians pointing out the non-confirmation (shown below). Today’s article looks at why the transports have been lagging and whether or not their recent weakness relative to the industrials will continue.
Source: StockCharts.com
The markets correctly discounted an improvement in economic activity as several economic indicators experienced a rebound after the plunge seen in the last quarter of 2008. For example, the ISM Purchasing Managers Index (PMI) plummeted from 49.4 in August 2008 to 32.9 in December, but has since staged an impressive recovery to 42.8 in May of this year, though the index still shows a contracting economy as long as the index remains below 50.
ISM PMI
Source: Bloomberg
It was not surprising to see the Dow Industrials rally along with the improvement in the manufacturing PMI as the year-over-year (YOY) rate of change in the Industrials has a strong correlation with the average of the ISM manufacturing and non manufacturing indexes which is shown below.
Source: ISM, Dow Jones
While improvement has been seen in the manufacturing base of the economy from the collapse seen last fall, there is little to show for improvement in terms of transportation data to support the rally in the Dow Transports. The Cass Corporate Freight Shipments Index, which is based on transportation dollars and shipments of 1500 of Cass Information Systems clients, has failed to confirm the rebound in the Dow Transports. A similar occurrence was seen in the 2001 rally that saw the Transports stage an impressive rally while the Cass Freight Shipments Index continued to head south. It was only when the Cass Index bottomed that the Dow Transports put in their final bottom in early 2003. While the Dow Transports have rallied meaningfully off the March lows, the Cass Freight Shipments Index has merely stabilized and does not support the rally in the Transports.
Source: Cass Information Systems, Dow Jones
Not only has the Cass Freight Shipments Index failed to confirm the rally in the Dow Transports, but so too has the manufacturing shipments-to-inventory ratio (S/I) which has proven to be a reliable leading indicator for moves in the Dow Transports. The S/I ratio began to improve late in 2001 as the economy was moving out of a recession and staged another advance in 2003. So far U.S. manufacturers are still trying to get their inventories inline with current demand, and the S/I ratio needs to turn up from here or we will likely experience further weakness in the Transports ahead.
Source: Bureau of Census, Dow Jones
Drilling down further into the transportation sector shows that “green shoots” remain absent for the railroad industry. The YOY rate of change in the railcar shipments continues to contract at the sharpest rate in more than a decade. The Producer Price Index (PPI) for the rails shows incredible pricing power weakness as their shipping rates continue to decline. Railcar shipments are unlikely to show any stabilization until the YOY rate of change in retail sales bottoms as the two series are highly correlated. If retailers aren’t selling goods, then the rails are obviously not shipping it to them.
Source: Association of American Railroads, BLS
Source: U.S. Census Bureau, Association of American Railroads
Confirming the weakness seen in the railroad data is a lack of stabilization or any semblance of a rebound in truck tonnage. Truck tonnage showed a meaningful recovery in terms of its YOY rate of change after each recession as well as after the 1980s and 1990s mid-cycle slow downs, and needs to turn around to show economic activity is improving. Currently truck tonnage is declining at more than a 10% YOY rate and needs to pick up from here if the Dow Transports are going to advance beyond their recent highs.
Source: American Trucking Association
Signs of Improvement
While the Cass, railroad, and truck tonnage data fail to support the recent rally seen in the Dow Transports, improvement may be on the horizon. Though the YOY rate of change in the manufacturing sales-to-inventory (S/I) ratio has not shown any improvement as of yet, the same can not be said for the retail S/I ratio which improved prior to the rally in the Dow Transports, with the Transports typically lagging turns in the YOY rate of change in the retail S/I ratio by 4.5 months.
Source: Association of American Railroads, Bureau of Census
As the retail sector plays a greater role in the economy than the manufacturing sector, it would make sense to place greater weight on the retail S/I ratio than the manufacturing S/I ratio. Moreover, the YOY rate of change in the retail S/I ratio leads the YOY rate of change in the manufacturing S/I ratio by 4.5 months. Based on the improvement in the retail S/I ratio we should begin to see improvements in the manufacturing S/I ratio in the next month or so, which should then correspond to improvement in railcar shipments, giving greater strength for a move in the Dow Transports in the latter part of the summer.
Source: Bureau of Census
One last piece of information that may perhaps be signaling a turn in railcar shipment data is retail employment. The YOY rate of change in retail trade employment bottomed at -4.18% in March, coincident with the stock market bottom, and has improved for two straight months to -3.93%. The improvement is certainly nothing to write home about, but it does potentially mark a change in trend.
Source: Association of American Railroads, BLS
While the fundamental data above points to a potential turn in transportation data in the months ahead, what is likely to have the greatest impact on the Dow Transports is an ease in oil prices. While the Dow Transports were unable to surpass their May highs, the Dow Jones US Railroad and Trucking Indices were able to advance to a higher high. The industry causing the greatest underperformance of the Dow Transports are the airlines, which failed not only to exceed their May highs but have already given back much of their gains off the March lows. The likely main culprit for a weak airline industry has been the strong showing in crude oil, whose recent strong advance over the last month coincided with weakness in the airlines.
Source: StockCharts.com
The advance in crude is overdone and oil is likely to consolidate some of its recent gains as its three month rate of change was the greatest three month advance seen in nearly two decades. One has to go back to the Persian Gulf War in 1990 for a greater move. A decline in crude oil prices should help support the airlines and the overall transport sector, and coupled with improvement in transportation data may lead to strength in the Dow Transports to exceed their May highs, giving a more bullish tone to the stock markets in the latter part of the summer.
Source: StockCharts.com
For now, the markets are likely to digest some of their recent gains as they appear to have gotten ahead of themselves and are likely to consolidate over the next few months as economic fundamentals slowly improve over summer. Economic fundamentals should improve over the next few months as more and more funds from the stimulus package pore into the economy and the rate of decline in job losses moderates (though unemployment is not likely to peak until next year). If economic fundamentals fail to improve or at least stabilize a retest of the March lows is possible, which is why incoming data over the course of summer should be monitored closely.
