The divergence between two market indexes could mean market bulls will soon have a day of reckoning.
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.”