Strong relative performance suggests railroads are likely to lead the markets higher in the weeks ahead, and these three in particular will be good buys on pullbacks to strong support.

One key market sector that topped out in May was the Dow Jones Transportation Average. It had been a market-leading sector since the 2009 lows, but its weak performance last summer weighed down the overall market.

The railroads are a key portion of the transportation sector because of their value in the overall economy. Norfolk Southern Corp. (NSC) reported very strong earnings last week, which helped other railroad stocks surge. The recent report from the Association of American Railroads also helped, as the group reported that so far in 2011, rail traffic is up 1.7% over last year.

Several rail companies are experiencing an economy that is still growing despite the concerns over another recession. Select daily charts do show gaps from last week, so buying on a pullback to support is clearly the favored strategy.

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Chart Analysis: The Dow Jones Railroad Index is made up of nine different railroad companies. It is up a whopping 31% from the October lows at 609.75. There is next resistance at 835-852.

  • The relative performance, or RS analysis, has broken its short-term downtrend (line a), indicating that the long-term uptrend has resumed
  • It was positive that the weekly RS support (line b) held
  • Volume has been strong on the rally, and the on-balance volume (OBV) has broken out to the upside, surging above resistance (line c) and its weighted moving average (WMA)

CSX Corp. (CSX) gapped higher on Thursday and had previously closed above the resistance at $21.50, line d. The rising 20-day exponential moving average (EMA) is at $21 with further support in the $20.25 area.

  • The RS analysis bottomed in late September and overcame its downtrend, line 3, last week
  • The daily OBV completed a nice bottom formation when resistance at line f was overcome. It has turned up sharply since
  • The weekly OBV (not shown) has moved back above its weighted moving average
  • There is next resistance at $24.30-$25.50

NEXT: 2 More Railroads Poised to Lead the Market Higher

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Impressive earnings from Norfolk Southern Corp. (NSC) have caused several analysts to raise their price targets, with one as high as $95.

  • The daily chart shows a gap in the $70.98-$73.40 area that is likely to be at least partially filled on a market correction. There is further support at $68.50
  • The downtrend in the daily RS, line b, was broken on October 20. The RS did bottom (line c) ahead of prices
  • The downtrend in the daily OBV has been broken, but so far it is acting weaker than prices
  • The weekly OBV (not shown) has moved above its weighted moving average
  • There is now a band of resistance in the $76-$78.60 area

Union Pacific Corp. (UNP) dropped to a low of $77.43 in early October but closed well above $100 last week. It released earnings on October 21 that beat analyst estimates. There is next major resistance at $106-$107.89.

  • There is support at the gap between $98.50 and $99.87, with stronger support in the $94 area, line e
  • A daily close below $88.80 would reverse the positive signal from the upside breakout
  • The RS line has confirmed the price action and moved through its downtrend, line f
  • The RS bottomed ahead of prices, as indicated by its uptrend, line g
  • The daily OBV looks strong, having moved through resistance (line h) just after the lows. It is well above its weighted moving average
  • The weekly OBV (not shown) has already made new all-time highs

What It Means: The impressive relative performance analysis of the railroads suggests that they are likely to again lead the market higher. With crude oil prices likely to move higher as well, the railroads will also increase their edge over the trucking industry.

Finding a good entry point will be more difficult, as all three companies have tested the daily Starc+ bands last week and are not far below the weekly Starc+ bands.

As I discussed in an earlier article, “buying on a dip” refers to a specific level, not just a broad market pullback. A two-stage entry strategy seems best, buying half the position at a partial filling of the gap and the other half closer to the breakout level.

How to Profit: For CSX Corp. (CSX), go 50% long at $22.16 and 50% long at $21.66 with a stop at $19.94 (risk of approx. 8.9%). Cancel the order if $24.50 is hit first.

For Norfolk Southern Corp. (NSC), go 50% long at $72.54 and 50% long at $71.62 with a stop at $65.22 (risk of approx. 9.5%). Cancel the order if $77.00 is hit first.

For Union Pacific Corp. (UNP), go 50% long at $98.66 and 50% long at $96.32 with a stop at $88.36 (risk of approx. 9.3%). Cancel the order if $105.60 is hit first.