The Dow Jones Transportation Average index has underperformed the broader Dow Jones Industrials Average and entered correction territory this month, leading some market watchers to speculate that a deeper U.S. selloff could be coming soon.
Under the so-called Dow Theory, divergence between the Dow Transports—20 companies in the rail, airline and shipping industries—and the Dow Jones Industrials Average has long been followed as an early indicator of trends in the overall stock market.
Weakness in companies at the heart of the economy’s supply chain would—so the logic goes—portend looming troubles for the economy and earnings.
However, while developments related to Greece, China, Puerto Rico and even the U.S. Federal Reserve (Fed) have the potential to unsettle stocks in the short term, the recent outsized setback in the Dow Jones Transports tells us more about subsector trends than about the health of the equity market.
Though the logic of Dow Theory appears solid, we think there are reasons to be suspicious of it today.
The U.S. recovery doesn’t appear over
That U.S. and global economic activity is likely to be more subdued than was thought at the beginning of the year may explain some of the pullback in the Dow Transports.
The Dow Transports correction is partly a function of valuation
The recent correction in transports has to be viewed in the context of the index’s 120 percent advance from its 2012 lows.
According to Bloomberg data, the two years heading into the end of 2014, the Transport Index posted returns double that of the broader Industrials index.
Keep in mind as well that according to Bloomberg data, Transports outperformed by a wide margin during 2014 thanks to several factors: continued growth in e-commerce, lower oil prices benefiting airline earnings and expected crude-by-rail volume growth.
This year, the bottoming in oil prices, weak natural gas prices (which reduces demand for coal shipments), declining trade volumes and lackluster consumer spending have brought Transports valuations back down to earth.
Profound changes in the underlying economy during the past century—the rise of services, growth of the digital economy and declines in manufacturing—limit the potential application of the Dow Theory.
Recent divergence between Industrials and Transports would be more compelling if it was confirmed by a sharp drop in any new orders or manufacturing surveys.
However, here the evidence is mixed.
To be sure, we are witnessing an increasing number of global risks surrounding unsustainable debt and credit creation—consider this summer’s headlines out of Greece, Puerto Rico and China.