The U.S. stock market has been on a tear so far this year, staging a rally that has lifted the Dow Jones industrial average to five-year highs, but behind the apparent strength lurks potential trouble, at least in the eyes of those chartists who take technical indicators to heart.
While the Dow Jones industrials average has gained some 10 percent year-to-date, the Dow Jones transports average—the segment of the market that tracks the performance of transportation stocks such as railroads and FedEx—is actually down some 2 percent so far this year.
Both segments of the market often move in tandem, which makes this divergence in performance a noteworthy event that could be indicative of a looming correction, at least according to the decades-old Dow theory.
The Dow theory of stock price movement—coined more than a century ago based on the works of Charles Dow—suggests that a bull market in industrials will not last unless transportation is rallying too. For the market to be truly strong, goods need to be fabricated, but the transportation of those manufactured goods need to be alive and well too, so the argument goes.
The theory, which is a form of technical analysis many have looked to in the past for indication of market direction, concludes that a divergence between these two benchmarks could reflect the fragility of a rally in the Dow Jones industrial average.
“What we are seeing is emblematic of the entire economy,” Jonathan Citrin, head of CitrinGroup, said of the different performance between industrials and transportation stocks. “We have high unemployment, high fear of inflation, not a ton of good economic news and yet, the market is going up.”
“The fundamentals of the economy are not good, but consumer confidence just hit a seven-month high,” Citrin added. “I think we see what we want to see, and there’s a big divergence here between fundamentals and sentiment. It’s a serious warning sign.”
From a historical perspective, even during the height of the credit crisis, industrials and transportation stocks pretty much moved together. Both sectors seemed to have hit a peak in May 2008 and then slid to a bottom in March 2009. By that time, the Dow Jones industrials had lost about half its value, led by a decline in transportation stocks.
“Both sectors are leading indicators,” Citrin said. “We can’t look at one and ignore the other.”
How can the Dow Jones industrial average be as much as 21 percent higher in the past year—and the S'P 500 be up 23 percent in the past 12 months—while the U.S. economy is growing at a mere 1.5 percent annualized rate remains a mystery, he noted.
If anything, he added, many transportation companies have recently revised their earnings forecasts downward rather than upward, adding fodder to the argument that the ongoing momentum in stocks is not built on rock, but rather on sand.
“It’s just a matter of time before industrials are going to confirm what we are already seeing in transports,” Citrin said. “Investors will get hurt when that happens.”
The Technology Caveat
That entire argument takes a back seat for those who look at tech stocks as the next big thing in the U.S. economy. Indeed, companies like Apple and Google have stolen the headlines for months now, performing so impressively that they have left even market bulls at times baffled.
Apple’s stock is up some 64 percent year-to-date and it continues to rally even as iPhone 5 sales fail to meet expectations. Meanwhile, tech giant Google has rallied more than 33 percent in the past three months alone. And the list goes on.
The importance of this tech rally as far as the Dow theory is concerned is that the Dow Jones industrial average doesn’t have any of the big tech names among its top holdings, because the index is price weighted rather than market capitalization weighted—the exception here being IBM, which represents about 11.5 percent of the benchmark.
That lack of exposure to some of today’s bellwethers of the economy makes the Dow a somewhat obsolete measure of the overall health of the economy, Paul Weisbruch, of Street One Financial, told IndexUniverse.
“The fact that technology accounts for such a large percentage of the S'P 500 Index—AAPL is No. 1 at 4.9 percent—shows that the basic tenets of ‘following the industrials and transports’ as market barometers has lost significance over time as new-economy stocks such as AAPL have ramped up their market caps,” Weisbruch said.
Arguing that while the Dow indexes “are not completely irrelevant” because of their lack of tech exposure, Weisbruch said that many fundamentally weighted strategies offer a more accurate assessment of the health of the economy.
“For more ‘pure’ analysis, we prefer to look at some newer and innovative indexes in conjunction with the S'P and Russell indexes,” Weisbruch said, citing the benchmarks that underlie a number of popular ETFs, including with volatility and beta screens.
Weisbruch included on that list funds such as the $2.46 billion PowerShares S'P 500 Low Volatility Portfolio (SPLV) the $105 million PowerShares S'P 500 High Beta Portfolio (SPHB), the $364 million iShares MSCI USA Minimum Volatility Index Fund (USMV) and the iShares MSCI All Country World Minimum Volatility Index Fund (ACWV).
“They weren’t on anyone's radars just a year or two ago, and now these, along with 'fundamentally weighted' indexes—such as PRF, DLN and RWL, for example—are more ‘true’ barometers of material fundamental changes that may be going on behind the scenes, and how these changes may filter throughout time vis-à-vis higher/lower stock prices,” he added.
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