Divergence Widens

5/25/2015


The Dow Jones Industrial Average and S&P 500 Index have reached fresh all-time highs, helped by gains in financials, health care, and technology. But the Dow Jones Transportation Average has continued to flounder, reflecting doubts about the airline industry's resurgence and weakness in the U.S. industrial economy.

Unless this month's new highs in the Industrials are confirmed by a close in the Transports above their December all-time high of 9,217.44, we are likely to keep some cash on the sidelines. Still, we are unlikely to raise cash aggressively as long as the broad market is moving mostly higher and we are still finding reasonably valued growers. For now, our Long-Term Buy List has 82.4% in stocks, versus 84.8% for our Buy and Focus lists.

Industrial sector slumps

Transportation stocks represent less than 3% of the U.S. stock market's value, and the Dow Jones Transportation Average is a price-weighted index of just 20 stocks. So, some investors question whether it makes sense to attach such importance to the December high. Our answer has three parts:

• First, the slump in the Dow Transports is no statistical fluke. Broader, capitalization-weighted indexes of the transportation sector have charted similar paths. All four major groups in the Transports — airfreight, airlines, railroads, and trucking — have come under pressure in 2015.

Airlines have slumped on worries regarding excessive capacity growth and heightened price competition. Railroads have been hurt by cutbacks in the energy sector, which has weighed on shipments of crude oil, sand, and energy-related equipment. Truckers and airfreight companies have been slowed by weakness in the U.S. industrial sector, with sluggish growth abroad also weighing on airfreight volumes.

• Second, the slump in transportation stocks has been mirrored by a slump in related economic indicators. U.S. industrial production — a measure of the output of manufacturers, utilities, and mines — declined for the fifth consecutive month in April. Production in April was up just 1.9% from a year earlier. Oil and gas drilling was down more than 46% from a year earlier.

• Third, we're not betting against the market; we're holding some cash in reserve unless the Transports can provide an all-clear signal. For a bear-market signal under the Dow Theory, the Dow Industrials would need to close below the Jan. 30 closing low of 17,164.95.

Until we get a bull-market confirmation or a bear-market signal, we're likely to keep doing what we're doing — looking for opportunities one stock at a time. We may lift our exposure to equities to about 90% if we find another couple of stocks we like. Similarly, company-specific disappointments could result in our exposure dropping to 80%.


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