Another Fundamental Look at the Recent Dow Non-Confirmation
By Chris Puplava, October 28, 2009
Much was made in June about the Dow non-confirmation as the Dow Jones Industrial Average exceeded its May high while the Dow Jones Transportation Average did not. The non-confirmation was not an early warning sign that the market rally was finished, but rather warned of a short-term correction that ended with the Dow non-confirmation later resolved in late July as both averages exceeded their June highs.
Back in June I took a fundamental look at transportation data to help explain why the Dow Transports were lagging the Dow Industrials and to see if their weakness was pointing to something more onerous in the offing. At the time transportation data was showing signs of stabilization and leading transportation indicators were showing that improvement were likely to be seen over summer and into the fall, not giving any major warning signals. What appeared to be the real culprit for the Dow non-confirmation at the time was that the airline industry was severely lagging due to a strong advance in crude oil prices. The following commentary was given in June explaining this dichotomy:
While the fundamental data above points to a potential turn in transportation data in the months ahead, what is likely to have the greatest impact on the Dow Transports is an ease in oil prices. While the Dow Transports were unable to surpass their May highs, the Dow Jones US Railroad and Trucking Indices were able to advance to higher highs. The industry causing the greatest underperformance of the Dow Transports are the airlines, which failed not only to exceed their May highs but have already given back much of their gains off the March lows. The likely main culprit for a weak airline industry has been the strong showing in crude oil, whose recent strong advance over the last month coincided with weakness in the airlines.
The advance in crude is overdone and oil is likely to consolidate some of its recent gains as its three month rate of change was the greatest three month advance seen in nearly two decades. One has to go back to the Persian Gulf War in 1990 for a greater move. A decline in crude oil prices should help support the airlines and the overall transport sector, and coupled with improvement in transportation data may lead to strength in the Dow Transports to exceed their May highs, giving a more bullish tone to the stock markets in the latter part of the summer.
Crude oil did in fact sell off from roughly $75/barrel to $60/barrel in June and then consolidated for the next several months up until the recent breakout towards $80/barrel. Weaker oil prices and further stabilization in the economy were all the transports needed to breakout to a new high, with the general market along with it. However, we find ourselves in a similar situation where the Dow Transports this month did not exceed their September highs while the Dow Industrials did, leading to another Dow non-confirmation.
Back in June-July the Dow Transportation Average did not break down below the May and June lows and so a double-top reversal pattern was not seen, and the intermediate trend in the Transports remained up. The Transports are facing yet another significant juncture as they are testing their recent lows, and a significant break below 3656 would confirm a double-top reversal and signal a move towards roughly 3233, just above the rising 200d MA.
Technical backdrop this time around is more troubling
While the potential double-top in May and June did not lead to anything other than a consolidation in the transports, this time around the technical picture is more worrisome. For example, only the Dow Jones US Airline Index failed to breach its May high while this time all three industries failed to exceed their September highs. The Dow Railroads are the strongest among the group but have the potential to form a double top as they test their recent lows, while the Dow Trucking Index has formed a confirmed double-top as it has broken below its October lows. And again the airlines were the weakest link as they failed to even form a double-top and instead have put in a series of lower highs and lower lows.
As in June/July, a USD rally may spark a sell off in oil which would be supportive of the airline industry. The Dow Jones US Airlines Index is still holding its March-June trend line and may find support near the August lows and the rising lower trend line at $45. Strengthening in the Dow Transport sector’s weakest link would likely bring support to the overall sector, with oil and the USD likely holding the key.
Fundamentals for the transports appear to be a mixed bag
As highlighted in June, the advance in the Dow Industrials was supported by improvements in the manufacturing and non-manufacturing ISM indexes with the average of the two moving into expansionary territory (> 50), which helps explain why the Dow Industrials bested their September highs this month.
Source: ISM, Dow Jones
One fundamental data point explored in June was the Cass Corporate Freight Shipments Index. The index is a great snapshot into the transportation industry as the index is based on transportation dollars and shipments of 1500 of Cass Information Systems clients. Back in June the Freight Shipments Index had merely stabilized and did not support the current rally in the Dow Transports and was indeed a red flag. However, since June the index has increased off the lows near 0.90 but the meager improvement does not appear to justify the advance seen in the Dow Transports and I would still classify this indicator as a cautionary flag.
Source: Cass Information Systems, Dow Jones
Conversely, one indicator that has improved considerably since June is the manufacturing shipments-to-inventory ratio, indicating manufacturers are brining inventory levels more in-line with apparent demand, and the ratio does not appear to show any signs of peaking as of yet, so no cautionary flags here.
Source: Bureau of Census, Dow Jones
One area of concern that would still be characterized as a red flag is the weak fundamental backdrop for the railroads. The year-over-year (YOY) rate of change in railcar shipments bottomed in 2000 and began to advance considerably in late 2001 as the recession in the US was ending. The YOY rate of change in railcar shipments entered negative territory in 2006 and remained so with significant deterioration last year. Railcar shipments are merely stabilizing at severely depressed YOY levels and it is hard to be bullish on the rails given weak shipment data. Particularly so in a depressed pricing environment as the PPI for rail transportation shows that railroads have no pricing power in the current climate.
Source: Association of American Railroads, BLS
While it is quite hard to find any “green shoots” in the railroad industry, there has been some improvement for the trucking industry. The YOY rate of change in the truck tonnage index has improved along with the YOY rate of change in the Dow Transportation Index. While there is certainly improvement in truck tonnage the index is still declining YOY and the current YOY rate of change is nearly below the trough of the last recession, which is hardly encouraging.
Source: American Trucking Association, Dow Jones
Continuing with the mixed bag theme for fundamental data, the last two series tend to paint different pictures for the transports. The final low for the Dow Transportation Index did not occur until consumer confidence did in early 2003, and while consumer confidence has stabilized it certainly hasn’t improved to levels that would justify the Transports move this year.
Source: ISM, Dow Jones, ABC News/Washington Post
While the consumer confidence index does merit a call for celebration, one indicator still gives hope for greater improvements to come in the manufacturing sector that perhaps could lift the overall transportation sector. Back in June the following chart was shown that was indicating a likely improvement in the manufacturing sales/inventory ratio, which has indeed improved. Not only has the manufacturing sales/inventory ratio turned, but there has been greater improvement in the retail sales/inventory ratio which leads the manufacturing ratio by four and a half months, with the following relationship representing perhaps the most bullish development for the transports.
Source: Bureau of Census
In summary, the technical backdrop for the Dow Transportation Average appears to be in a more precarious position than it was case in June when it was forming a potential double-top. Back in June the weakness in the Transports could be placed solely on the airlines, while the same can not be said this time. In the current situation weakness is most pronounced in the airlines as it was in June, but the railroads and trucking industries have also failed to exceed their September highs, giving a greater probability for an actual confirmed double-top in the Dow Transports than was the case in June. While the fundamentals have improved in many economically-related data series, the improvement does appear to justify the advance seen in the Dow Transports since the March lows, thus investors should likely take a more cautionary stance in the given climate. The Transports have already decidedly broken their March-July trend line and have marginally fallen below their early October lows. Further weakness in the Dow Transports would confirm a double-top and signal greater market deterioration ahead. Whether or not the Transports put in a double-top will likely be decided tomorrow given the all important Q3 GDP report. Thus, tomorrow should lead to some fireworks one way or the other, with bulls “hoping” for a positive surprise.
© 2009 Chris Puplava