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
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."
The Technology Caveat
That entire argument takes a back seat for those who look at
tech stocks as the next big thing in the U.S. economy. Indeed,
companies like Apple and Google have stolen the headlines for
months now, performing so impressively that they have left even
market bulls at times baffled.
Apple's stock is up some 64 percent year-to-date and it
continues to rally even as iPhone 5 sales fail to meet
expectations. Meanwhile, tech giant Google has rallied more than 33
percent in the past three months alone. And the list goes on.
The importance of this tech rally as far as the Dow theory is
concerned is that the Dow Jones industrial average doesn't have any
of the big tech names among its top holdings, because the index is
price weighted rather than market capitalization weighted-the
exception here being IBM, which represents about 11.5 percent of
That lack of exposure to some of today's bellwethers of the
economy makes the Dow a somewhat obsolete measure of the overall
health of the economy, Paul Weisbruch, of Street One Financial,
"The fact that technology accounts for such a large percentage
of the S&P 500 Index-AAPL is No. 1 at 4.9 percent-shows that
the basic tenets of 'following the industrials and transports' as
market barometers has lost significance over time as new-economy
stocks such as AAPL have ramped up their market caps," Weisbruch
Arguing that while the Dow indexes "are not completely
irrelevant" because of their lack of tech exposure, Weisbruch said
that many fundamentally weighted strategies offer a more accurate
assessment of the health of the economy.
"For more 'pure' analysis, we prefer to look at some newer and
innovative indexes in conjunction with the S&P and Russell
indexes," Weisbruch said, citing the benchmarks that underlie a
number of popular ETFs, including with volatility and beta
Weisbruch included on that list funds such as the $2.46 billion
PowerShares S&P 500 Low Volatility Portfolio (NYSEArca:SPLV)
the $105 million PowerShares S&P 500 High Beta Portfolio
(NYSEArca:SPHB), the $364 million iShares MSCI USA Minimum
Volatility Index Fund (NYSEArca:USMV) and the iShares MSCI All
Country World Minimum Volatility Index Fund (NYSEArca:ACWV).
"They weren't on anyone's radars just a year or two ago, and now
these, along with 'fundamentally weighted' indexes-such as PRF, DLN
and RWL, for example-are more 'true' barometers of material
fundamental changes that may be going on behind the scenes, and how
these changes may filter throughout time vis-à-vis higher/lower
stock prices," he added.
Weisbruch was referring to the $1.44 billion PowerShares FTSE
RAFI US 1000 ETF (NYSEArca:PRF), the $1.27 billion WisdomTree
LargeCap Dividend Fund (NYSEArca:DLN) and the $158 million
RevenueShares Large Cap ETF (NYSEArca:RWL).
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