ETF Trends
ETF Trends

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.

Is a broader selloff ahead? Why or why not?Join in >

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

While Purchasing Managers Indices (PMIs) and some leading indicators have disappointed to the downside, they’re not suggesting that the economy is headed into a recession. 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. For instance, recent factory orders and Chicago Purchasing Managers data have been soft, but the national ISM Manufacturing index, particularly its new orders component, rebounded sharply in June.

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. These risks have the potential to further weigh on global markets, at least in the near term.

However, such risk aversion is likely to be short lived, given continued central bank accommodation in much of the world and some modest improvement in economic growth. As such, we remain overweight stocks, cyclicals and credit. As for the transports sector, we remain neutral on the broader industrials sector because of its stretched valuations, and we wouldn’t see the current pullback as an opportunity to add exposure. Rather, within cyclicals, we prefer the technology and financials sectors.

 

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog and you can find more of his posts here.

Kurt Reiman, a Global Investment Strategist at BlackRock working with Chief Investment Strategist Russ Koesterich, contributed to this post.