What's Up with the Transports?

03/02/2012 8:15 am EST

Focus: MARKETS

Richard Moroney

Editor, Dow Theory Forecasts

A rising tide supposedly raises all boats, but it seems that isn't the case this time around, and it's time to investigate what might be causing this odd predicament, notes Richard Moroney of Dow Theory Forecasts.

Soon after the S&P 500 Index reached post-crisis highs, the Dow Industrials closed above 13,000 for the first time since May 2008. But the Dow Transports stubbornly refuse to join the party, drifting lower since early February and raising questions among those watching the market averages. Among them:

Q: Why are the Transports lagging when the US economy seems to be strengthening? Are oil prices to blame?

A: A surge in oil prices, with benchmark US oil above $105 per barrel—up from $76 in September—represents a general threat to the economy and a particular threat to transportation companies. Also weighing on the Transports are mixed reports on factory orders and weak demand for coal.

Also, as founding Dow Theorist William Hamilton wrote in 1913, “The market does not trade upon what everybody knows, but upon what those with the best information can foresee.” Looking ahead, continued sluggishness from the Transports amid a continuation of the late-February dip in oil prices would be discouraging.

Also worth watching is the interaction of oil prices and energy stocks. When shares of oil producers stagnate amid rising oil prices, it suggests investors are worried that higher prices will sap the economy and erode energy demand.

Q: Does the recent divergence between the Industrials and Transports raise the risk of a near-term correction?

A: Yes, market corrections often follow periods of near-term divergence. Also pointing to a potential pullback: the extent of the rally since October, the optimistic investor sentiment revealed in surveys, and the high number of stocks trading above their 200-day moving averages.

Q: Couldn’t the Transports be signaling something more sinister, like a bear market? Isn’t it important for the health of a bull market that the Industrials and Transports advance together?

A: For a bear-market signal under the Dow Theory, both the Industrials and Transports need to violate significant lows. As we see it, no such lows have been established yet. Even declines as low as 11,440 on the Industrials and 4,480 on the Transports would be consistent with a typical correction.

Yes, chronic underperformance by the Transports would be a reason to doubt the staying power of a bull market, but recent action should be kept in perspective. After surging 33% from October 3 to February 3, the Transports have dipped about 4%.

Conclusion
While we would not be surprised by a near-term pullback, we are not worried enough to raise cash aggressively. Our buy lists have about 90% in stocks, with the remainder in a short-term bond fund.

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