Dow Transports Say: The Bull Market Lives!

Dow Theory, developed originally by Charles Dow, the founder and editor of The Wall Street Journal, is one of the oldest and most reliable methods of market analysis available to investors.  Without getting into all the particulars, one of the key tenets of Dow Theory is that both the Dow Transport Average and the Dow Industrial Average must confirm one another when bull and bear markets begin.  Below we examine exactly how this works.

But first, let’s take a brief look at the relationship that binds the Transports to the Industrials.

There are two aspects to traditional industrial sales: production and distribution.  When sales are good, production levels are high and the product in question is moved in quantity.  Dow Theory posits that this reality manifests itself in elevated prices in both the averages.  Transport companies profit handsomely for moving goods to market along with the manufacturers themselves.

Conversely, when economic contractions occur, less product is shipped and production slows.  This, too, manifests itself in downturns for both the Transports and Industrials.

More importantly, market turns, changes from bull to bear or vice-versa, occur when divergences occur in the averages.  Or to use Dow terminology, where “non-confirmations” occur.

A look at the charts below illustrate the point graphically.

The first chart represents the Industrials and Transports going back almost seven years to the beginning of the last bull leg which began in late 2002/early 2003 (#1).

From here, both Transports and Industrials continued to make higher highs, thereby confirming the bull market in stocks that existed for nearly five full years.  Their final joint highs were logged in mid- to late-2007 (#2), with the industrials lagging on this occasion by several months.

It’s precisely at this point that Dow Theory gives us information that other technical systems can’t. 

Take a look at the second chart – an expanded version of the green rectangle (#3).

From this chart we see plainly that new highs on both the indexes were set in July and October of 2007 (#1), before selling off to reaction lows in January of 2008 (#2).  From here, however, the two averages diverge significantly.

Whereas the Transports rose to better their previous highs of July 2007 (#3a), the Industrials bounced and then fell to new lows (#3b).

And what does our dependable Dow Theory have to say about this flagrant non-confirmation? 

Essentially, that there is no bear market here.  And until we see the transports confirming the new lows set by the Industrials, i.e., dropping to less than 3995 – their reading set at the January low – then we are still in a bull market.

How do we play a Dow Theory non-confirmation?

There are a number of ways to profit from such an occurrence.  Here we list just few of them.

Working on the assumption that we are in a bull market and that the Industrials are very shortly going to “catch up” to the Transports, and thereby narrow the gap between the two, there are two potential strategies to avail ourselves of.

1. Using options:

Sell transport index calls and industrial index puts.  The idea here is that one of the two positions will lose money, but at a slower rate than the other will gain.  If we are in a bull market, the Industrials will rise, entitling you to the entire premium of the sold put.  At the same time, the transports will rise more slowly giving you a slight loss, which will be more than offset by the premium initially collected on both.

2. Using ETF’s: 

• Like the options trade above, purchase Diamonds (NYSE:DIA), the Dow Industrials ETF, and short the Transport ETF, NYSE:IYT.  Same principle here: the two are bound two close the gap, meaning the DIA will rise faster than IYT.

or

• Buy the DIA or IYT ETF’s outright.

3. Single stock purchases:

Working on the assumption that the Transports have shown greater relative strength, find the best performing Transport companies for outright purchase.  Below we list just a few possibilities.

1. Alexander & Baldwin Inc. trades on the NASDAQ.  They’re a Hawaii based, diversified operation with emphasis on shipping, truck brokerage and logistics.  Best dividend of all the Dow Transports at a reasonable P/E.

2. GATX Corporation is another diversified transporter with railroad and shipping emphases.  Trades on The NYSE.  Attractive P/E ratio for the industry.

3. Overseas Shipholding Group Inc. also trades on the NYSE.  Primarily ocean going transporters of crude oil and petroleum products.  Own and operate fleet of 112 vessels.  Maybe the best metrics of the bunch.

Cheers,

Matt McAbby
Quantitative Analyst, Charts of the Week