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Is the Dow Transports Rally Telling Us Something?

Friday, March 18, 2016
Is the Dow Transports Rally Telling Us Something?

Authored by Saeculum Research

After more than a year of freefall, the Dow Jones Transportation Average has changed course: Since hitting rock bottom on January 20, the index has gained nearly 1,000 points. This recent boost makes some prognosticators and traders—those who swear by the Dow Transports as a leading indicator—hopeful that the index will pull up the rest of the stock market and perhaps the economy as well.

But so-called “Dow Theory” is a controversial science. Sometimes the Transports signal a coming turnaround. Other times, they signal—well, nothing at all. Besides, we don’t know quite yet if the recent rise has lasted long enough to indicate a true reversal.

The Transportation Average was created by Charles Dow back in 1884, making it America’s oldest stock index—even older than its better-known cousin, the Industrial Average. The original lineup included 11 companies, comprised of nine railroads and two non-rail firms (Pacific Mail Steamship and Western Union). The modern-day Transports feature 20 companies: six trucking/trans­portation firms, five airlines, four rail­roads, three delivery services, and two marine transportation companies. Each stock is weighted according to its relative importance, the top five being FedEx (accounting for 11.6 percent of the index), UPS (7.4 percent), Kansas City Southern (7.0 percent), Union Pacific (6.6 per­cent), and Ryder System (6.3 percent).

The Transports are held in high regard by market watchers because of the outsized role they play in Dow Theory. In the early 1900s, Charles Dow wrote a series of editorials for The Wall Street Journal that established a new form of technical market analysis later named Dow Theory. Dow believed that amid the market’s chaotic undulations, the Transports and the Industrials are reliable economic markers—and that market calls (bullish or bearish) should only be made when the two indices are moving in the same direc­tion. According to “Dow Theorists,” something momen­tous is happening when investors warm or cool on both industry and transpor­tation at the same time.

It has been suggested that the Transports are a leading indicator of both the economy at large and the stock mar­ket. After all, a decline in shipments—an early-warning diagnostic of a market downturn—pulls down Transport stocks before it shows up in the rest of the econ­omy. In 2014, the Bureau of Transporta­tion Statistics (BTS) confirmed transpor­tation’s ability to forecast market swings: By tracing its own index back to 1979, the BTS was able to conclude that trans­portation “moves in conjunction with other indicators of the national econ­omy.” What’s more, researchers noted that the index’s turning points lead both economic growth and business cycles by an average of four months.   

A deep dive into the data confirms that, more reliably than the S&P 500 or the Industrials, the Transportation Aver­age turns sour months before downturns. Look back to the Great Recession: Trans­port stock prices began their plunge in June of 2007, while the S&P 500 con­tin­ued to climb until November. When the dot-com bubble burst in the early aughts, the Trans­ports were roughly 14 percent below their previous peak, decli­ning far earlier—and far steeper—than the S&P 500. Earlier down­turns tell the same story: The Transports started to slip in September of 1989, nearly a year before recession. Moreover, in each of these in­stances, the Transports began con­tracting at least four months before the Industrials did. To be sure, it’s less obvious how well the index pre­dicts market upswings.


Charles Dow’s original insights were eclipsed during the Great Depression, and were not resurrected until the Clinton years. In 1934, economist Alfred Cowles, after studying the market calls made by famous trader William Peter Hamilton, concluded that Dow Theory trading didn’t work: It would have yielded 12 percent annually from 1902 to 1929, 3.5 percentage points less than a buy-and-hold strategy. This practice fell out of favor until 1998, when researchers Stephen Brown, Alok Kumar, and William Goetzmann reexamined the earlier findings with an eye toward risk-adjusted returns—and discovered that a Dow Theory portfolio would have incurred a whopping one-third less risk (as measured by vola­tility) than buy-and-hold.

Given the index’s reputable track record, its steep decline during 2015 set off alarm bells. The index peaked on December 26, 2014, five months before the S&P 500. From that date on, transportation stocks plunged more than 30 percent before hitting their low on January 20 of this year, dropping nearly as steeply as they did during the Great Recession.

But in February, the Transports rallied, which has analysts sitting up in their chairs. What made last month’s near-1,000 point gain so surprising is that, for the first 11 days, it occurred despite the fact that the Industrials were still sliding. Analysts take any divergence—or “non-confirmation,” in Dow Theory terms—as a sign that the market may be at a tipping point (in this case, on the verge of recovery). Could, then, the Industrial Average’s surge since February 11 mean that the economy is getting back on its feet?

To be sure, there are plenty of other fac­tors driving the Trans­portation Average in conjunction with Dow Theory. For one, trans­portation stocks are inextricably tied to a freefalling industrial sector. Industrial pro­duction has con­tracted in recent months (with the Manufacturing Pur­chasing Managers’ Index still sitting below 50) due to lagging output, stagnant order growth, and a rising dollar that has dampened global demand for U.S. goods. The regulatory crackdown on coal has also been especially hard on rail companies that now earn less revenue per carload. (See: “Are Railroads Ready for the Long Haul?”)

Transportation’s 2015 decline seems even more ominous when considering that it oc­curred simulta­neously with a slash in energy prices—which ought to have made the index jump. Transport com­panies, after all, use a lot of energy. Airlines should have been especially boosted: Around one-third of their costs are fuel-related.

Only time will tell whether the past month’s recovery in Transport stocks will stick. Analysts aren’t yet buying in: Benzinga contributor Dana Lyons, for one, cautions that the rate of recovery is too sluggish to be permanent. Bearish forecasters likely think that the rebound is fueled by investors buying up stocks that they see as undervalued: After all, look at the bargain-bin price to earnings ratios of the Trans­ports—all of which fall below that of the aver­age S&P 500 company.

Considering the vulnerable state of the economy, forecasters are right to be skept­ical. The Commerce Depart­ment’s fourth-quarter GDP revision showed that inventories are building up, which simultaneously helps explain the Transports’ better-than-expected February (due to higher shipments last fall) and dampens the GDP forecast for next quar­ter. Meanwhile, America has been undergoing a systemic shift away from “old economy” goods and toward “new economy” services (see: “The Immaterial World”), which casts doubt on the very future of the transportation sector. Given these circumstances, it will be some time before most analysts turn bullish about the prospect of economic recovery.



  • Beware: The Dow Transports rally isn’t a sure sign of recovery. Many market watchers believe that the Dow Jones Transportation Average is a leading indicator (by several months) of the overall econ­omy and stock market. Accordingly, many obser­vers expected—and received—bad stock market news after the index began plunging in early 2015. Since mid-February, however, transportation stocks gained nearly 1,000 points—a resurgence that has these ana­lysts anticipa­ting a full market recovery. But this might not be the case. The index is heavily influenced by the indu­strial sector (which continues to struggle) and energy prices (which fell last year while transportation stocks contin­ued to freefall). There is reason to be skeptical that last month’s recovery will endure.
  • Keep in mind that 2015 was a uniquely bad year for Transport stocks. For railroads reliant on carloads of coal and oil for profit, last year’s energy slump meant less revenue per car. Airlines, which stood to gain the most from record-low oil prices, were toying with expanding their capacity last year, which spooked investors fearful of diminished pricing power. The trucking sector, meanwhile, is moving away from long-term contracts (and their guaranteed revenue)—and is experiencing a driver shortage nearly 50,000 strong. Even Transport stars FedEx and UPS have been (some­what) marginalized by the rise of the sharing economy and last-mile delivery options. (See: “Delivering the World to Your Doorstep.”)
  • Understand that as the Transports rebound, invest­ors are looking for underlying value. Railroads have been the biggest winners over the month of February, with giants like Norfolk Southern rebounding despite a continued slide in energy prices. How is this possible? Quite simply, many believe rail to be undervalued and think it can’t possibly fall lower. That’s essentially what stock guru Jim Cramer said earlier this week when he called CSX a great value buy. TIAA managing director Stephanie Link even bought shares of Union Pacific for her own fund. Traders are picky in choosing a winner and see rail—a consistent past performer—as a wise bet.
  • Remember that supply and demand may help explain the Transportation Average’s turnaround. As opposed to traders simply getting hot on the Transports, the February rally may be chalked up to a thinning out of capacity. Much of 2015’s decline came from a dearth of global trade (fueled by record-low Chinese imports), which gave rise to excess shipping capacity and hammered prices. While China’s slowdown won’t end any­time soon, there’s evidence that global trade prices are at least stabilizing: The Baltic Dry Index (which measures prices of raw goods shipments), after plum­meting more than 75 percent between August 5 and February 11, has gained almost 40 points over the past three weeks.

Material posted on this website is for informational purposes only and does not constitute a legal opinion or medical advice. Contact your legal representative or medical professional for information specific to your legal or medical needs.

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