Transports In Focus

1/13/2014


Confirmation, the idea that both the Dow Industrials and Dow Transports need to reach significant highs or significant lows for a change in the primary trend, is a central tenet of the Dow Theory. That means the share-price action of 20 stocks from the transportation sector, which in total represents less than 3% of the U.S. stock market's value, will go a long way in determining whether the Dow Theory remains in the bullish camp.

Does that make sense?

The short answer, based on long-term results, is yes. The Dow Theory, while not foolproof, has compiled an impressive record of keeping investors on the right side of the primary trend over more than 100 years. And Dow Theory Forecasts ranks among the nation's best investment newsletters for market-timing over the last 25 years, partly because of our interpretation of the Dow Theory.

The long answer, based on near-term prospects, is also yes. For at least five reasons, the Transports are a key barometer for 2014:

• Recent strength in the price-weighted Dow Transports, up 17% since the beginning of September, is no fluke. Broader, capitalization-weighted indexes of the transportation sector have also surged, and all major transport groups have participated.

• The vast majority of the market's advance over the past year reflected rising price/earnings ratios. With valuations now somewhat expensive versus 20-year and 50-year norms, faster earnings growth may be needed for the market to make much headway. That seems especially true for the economically sensitive Dow Transports, which as a group still have decent upside if they meet expectations for year-ahead profits.

Assuming all 20 of the Dow Transports meet consensus next-year profit estimates and maintain today's P/E ratios, the average would trade at 9,150, up 25%. Assuming all meet next-year estimates but P/Es for all 20 stocks revert to five- or 10-year norms, the average would trade at 8,000 to 8,100, up 10% to 11%.

• The action of the Transports will shed light on some of the central questions facing an investor in U.S. stocks. Is the global economy truly on the rebound, or will a slowdown in China offset a return to growth in Europe? Does the resurgence in U.S. energy production have legs? Has the U.S. economy finally reached the point of self-sustaining lift-off?

• The airline industry is one to watch. Airlines now represent nearly 13% of the Dow Transports, an unusually high percentage for the notoriously volatile group. But the airline industry seldom had such strong fundamentals. In fact, four of the five airline stocks in the Dow Transports earn Quadrix Overall scores above 95. Will airlines be able to maintain their profit margins if labor costs begin to rise? We shall see.

• The railroads, always worth watching, are especially interesting today. Three of the four railroad stocks in the Transports earn Overall scores above 80, reflecting decent operating momentum and reasonable valuations relative to expected 2014 earnings. With U.S. exports at record levels and U.S. industrial production on the rebound, a big downturn in the railroad stocks could undermine some of the best arguments of the bulls.

Conclusion

The Transports' economic sensitivity makes them a useful barometer. For now, with the Industrials and Transports reaching all-time highs in late December, the Dow Theory is squarely in the bullish camp. Our buy lists have 91% to 93% in stocks.


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