Charles Dow developed what would become the Dow Theory in the late 1800’s. There several different components to the theory and many investors still subscribe to his philosophies. One aspect in particular that I have found to be helpful and valid is the idea that market indices and industries should confirm one another.
When Dow was developing his theories, the United States was a growing economy that relied heavily on industry. Factories were scattered throughout the country and shipping goods to customers in various population centers was a thriving industry itself. The first two stock averages Dow created were made up of industrial companies and another one was made up rail companies.
According to Dow’s line of thinking, a bull market in the industrial sector couldn’t happen unless there was also a rally in the rail sector. If manufacturers were producing more goods, they would have to transport more goods to market and the transportation companies would experience rising profits. The logic is that the industrial sector and transportation sector should be moving in the same direction.
Of course, a lot has changed since Dow was developing his theory. The U.S. has shifted to more of a service-oriented economy and technological developments have reduced the need for shipping some products. Think about the software industry. It used to be that they had to ship a disk or drive of some sort, but the internet allows the same files to be delivered electronically.
Even with the changes, transportation is still needed for most goods. Because transportation of goods is so important to our economic health, it led me to look at the Dow Jones Transportation Index (TRAN) and how it is performing compared to the S&P and other indices. What I found was that the transportation index has gotten hit hard during the month of October.
This chart is up to the minute through midday on Thursday, including the big rally that is underway in the morning. As of the close on Wednesday, the TRAN was below its 24-month moving average and was down over 12% on the month.
We see that the index had just hit an all time high in September and that is also what happened to the S&P. The Dow hit its all-time high early in October, but the Nasdaq Composite and the Russell 2000 hit their highs in August before both fell in September.
The Russell 2000 represents small-cap stocks and to some degree it represents the risk appetite of investors. When investors are willing to take on more risk because they are bullish on the economy, small-cap stocks can offer greater returns.
Looking at the monthly chart of the Russell we see that the index is down 11.5% so far in October and it has fallen below its 12-month moving average. It was also below the 24-month moving average as of the close on Wednesday.
Looking at the TRAN and the Russell together, they are both experiencing much steeper losses in October than what we are seeing from the Dow, S&P, and Nasdaq. The main three indices have all lost less than 10% and none of them have come close to their 24-month moving average.
Seeing transportation and small cap fall faster than the overall market caused me concern and therefore I went back and looked at how the TRAN and Russell performed in 2007, before the bear market started.
The chart below shows the performances of the Dow, Nasdaq, Russell, S&P, and the Transportation Index from the end of 2006 through November 21, 2007. The Russell dropped just over 6% during this period while the TRAN dropped 4.25%. The other indices were flat or showed positive returns during the period.
I also noticed that the TRAN had been leading the other indices for a great deal of 2007, before getting outpaced by the others after the middle of the year.
That time period was 226 trading days long and after looking at that time period, I looked at the last 226 trading days. What I found was a similar development. The Russell lost 4.45% and the TRAN lost 2.76%. The other three indices were in positive territory during the time period. I also took note of the fact that for the first few months of this period, the TRAN led the other four indices.
One thing that is different about the two time periods is how the Russell performed. During the first time period (2007), the Russell lagged the others most of the time. During the current period the Russell outperformed all but the Nasdaq through the first half of the year.
The bear market in 2007-2009 was a little different than other bear markets in history. It started as credit markets locked up and it became more difficult for companies and individuals to borrow. It became known as the financial crisis, but even as that bearish period was getting started, it was the TRAN and the Russell that turned lower first.
You can add this development to the list of concerns I have about the stock market right now. That list includes the indices in danger of closing below their long-term moving averages, the highest consumer confidence readings since 2000, the high levels of investor optimism, the big jump in the 10-year treasury rate… What all of these things tell me is that we should be preparing for a longer lasting downturn than what we have seen so far.