Looking For Confirmation

2/7/2011


The Dow Industrials cleared 12,000 to reach 31-month highs, with solid quarterly results and evidence of global economic recovery countering uncertainties related to the turmoil in the Middle East. We'd like to see the new highs confirmed by a close in the Dow Transports above their Jan. 13 high of 5,229.47, but for now a mostly invested, opportunistic posture remains appropriate. As a partial hedge, our buy lists have 12% to 15% in a short-term bond fund.

Watch the Transports

For at least three reasons, a close in the Dow Transports above 5,229.47 would be noteworthy:

• Under the Dow Theory, divergence between the Industrials and Transports signals an increased risk of a secondary reaction or a shift in the primary trend. When both averages are acting in harmony, reaching new highs at roughly the same time, a bull market is likely to continue for a considerable time. But an unconfirmed new high indicates uncertainty regarding the business outlook — and often serves as an early warning of a potential turn in the market's tide.

• News regarding the current state of the economy has been mostly good, so a failed attempt at new highs from the economically sensitive Transports would highlight doubts regarding the sustainability of the economic recovery. The ISM manufacturing index reached a more than six-year high in January, mirroring overseas gains in the factory sector. Yet, on average, the 20 stocks in the Dow Transports earn below-average scores for the most forward-looking categories in Quadrix — Earnings Estimates and Performance.

• Action in the Transports will depend on the answers to some timely questions. Is a jump in oil prices, up more than 5% since street protests erupted in Egypt, likely to derail the economic recovery? Is China, facing rising inflationary pressures as its economy booms, headed for a sharp slowdown? If the answer to either of those questions is yes, transportation stocks are likely to struggle in 2011.

Conclusion

If the Transports fail to surpass 5,229.47 before the next market pullback, our concern regarding the market outlook will grow. But with the Transports roughly 3% from new highs and the broad market moving higher, raising cash at this point seems premature.

Among transportation stocks, railroads earn the highest Quadrix scores, led by a 97 Overall score from CSX ($72; CSX). The stock, a Focus List selection, represents a top pick for investors seeking cyclical exposure.


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