Rails Still Worth Watching


Helped by strength in railroad stocks, the Dow Jones Transportation Average has rallied within 2% of its April closing high of 8,109.19. A close above that level would put the Dow Theory in the bullish camp — and trigger an increase in our equity exposure. For now, our buy lists have about 81% in stocks.

The original bellwethers

Railroads were among the first truly national corporations. They tied the country together in a whole new way, and their decisions could make or break entire communities.

When Charles Dow introduced his first stock average in 1884, nine of the 11 stocks were railroads. In 1896, Dow introduced an average of industrial stocks and dropped the non-railroad stocks from his original index, creating the 20-stock railroad average.

In 1970, the railroad average was renamed the Transportation Average, and since then railroads have seen their bellwether status continue to diminish. Railroads, once widely represented among the most valuable U.S. companies, now account for less than 1% of the S&P 500 Index. Combined, all transportation companies represent less than 3%.

Railroads make up 24% of the price-weighted Transportation Average, versus 31% for airfreight, 19% for airlines, and 12% for trucking. Still, we see the railroads as a key group to watch right now, for several reasons.

First, the group remains closely tied to the fortunes of the industrial sector, which has dragged on the broader U.S. economy since oil prices crashed in late 2014. With employment, consumer spending, and housing showing decent strength, a sustained pickup in industrial activity could help U.S. gross domestic product finally accelerate north of 2%. In a 2014 study, the U.S. Department of Transportation concluded that freight volumes show a "strong leading relationship to the economy."

Second, railroads provide a direct read on the oil bust. While shipping oil by rail probably won't return to pre-2014 levels anytime soon, prices for the sand used in fracking have stabilized lately amid signs of improving demand.

Third, railroad stocks have been confirming signs of economic improvement. Purchasing-manager surveys suggest U.S. manufacturing activity has rebounded in the third quarter, and global economic reports have exceeded expectations by an unusually wide margin lately. The Department of Transportation says seasonally adjusted U.S. freight volumes have rebounded since March, which may help explain why all the major U.S. and Canadian railroad stocks are trading near year-to-date highs.

Fourth, with airfreight stocks also near year-to-date highs, continued strength in railroads could be enough to push the Transportation Average above 8,109.19.

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