Two important indexes which particularly reflect the strength of the domestic economy are the transports and the small caps index. Both of these are more leveraged to the economy than the large cap stocks which dominate the S&P 500, Nasdaq, and Dow. The large cap stocks have diversified cash flows from customers and operations all over the world usually with strong balance sheets, while the small caps primary customers remain in the US, thus are more vulnerable to economic fluctuations. Similarly, the transports index is composed of cyclical stocks more leveraged to the economy.
Both indexes have staged impressive moves to all time highs and have outperformed the traditional indices. Clearly, traders must have some optimism regarding economic prospects to continue buying and supporting prices at these levels. However, recent economic data is producing a much more sober and murky picture that is at odds with the ebullience of the transports and small caps.
In my opinion, the way to navigate this divergence is to stay with the market trend but more aggressively manage risk while keeping an eye on the data to confirm that the market is correctly anticipating better conditions.
The Transports Index is composed of 20 companies from marine transport, airlines, trucking, railroads, and delivery service groups. Some of the most well known companies include CSX, Fed Ex (NYSE:FDX), Conway, Delta Air Lines (NYSE:DAL), Norfolk Southern (NYSE:NSC), Southwest Air (NYSE:LUV), and UPS.
While the Dow Jones Industrial Average sits about 5% below its all time highs, the Transports crossed its all time high on January 15 and hasn't looked back as it continues to steam higher. Many market practitioners pay attention to "Dow Theory" which looks for confirmation from both indexes to new highs to confirm a bull market. Another belief is that typically transports should lead industrials as the transportation companies doing well indicate strong demand and production from industrial companies.
Of course, this theory was formulated during a time when the US economy was much different than it is today. Although it is still widely followed amongst a subset of traders and newsletter writers, I think its main value lies in confirming the market's primary trend. However, in a sense it is a lagging indicator and the interpretations remain murky, often massaged to justify a bias. For example, currently there is a debate whether "Dow Theory" is confirming a bull market based on the Dow or Transports exceeding the 2012 highs or no confirmation yet because the Dow remains below its all time high.
Below is the weekly chart of the Transports with the Dow below, displaying the impressive breakout. Also, on the chart are two instances of a non confirmation with the Dow making a new high in Spring and Fall 2012 with the Transports below 2011 highs. In both of these instances, a cautious stance would have been rewarded.
The ETF for the transports is the iShares Dow Jones Transport. Avg. (NYSEARCA:IYT).
The Russell 2000 is the most widely followed small cap index. The sectors with the most representation in the index are financials, health care, tech and consumer discretionary. Since it is a broader index, many believe it is a better representation of the US economy than the Dow or S&P500. The SPDR S&P 500 ETF Trust (NYSEARCA:SPY) sits 5% below its all time high while the iShares Russell 2000 Index (NYSEARCA:IWM) is at lifetime highs.
As previously discussed, the small caps index is more vulnerable to the economic strength and weakness due to weaker balance sheets, smaller size, and its customers residing in the US. This creates opportunities in both bull and bear markets for traders with risk appetite. Currently, it is fair to say that traders are feeling optimistic about the economy given that they are bidding up small caps with a frenzy and outperforming the S&P 500.
The below chart shows the Russell 2000 and below it is a ratio chart of the Russell 2000 and S&P 500 which shows the strong outperformance since November.
The biggest red flag to me in the economic data is the weakness in manufacturing. It is strange that the transports and specifically rail stocks are so strong even with manufacturing barely in expansion mode.
Another intrinsic weakness to this recovery and not entirely consistent with all time highs is the weak recovery in employment. The fall in the unemployment rate is deceptive as it is colored by people dropping out of the workforce. At some point, incomes and employment need to increase to generate demand for businesses' services and products.
Another headwind is higher oil prices which will take a chunk out of consumer spending if it continues to rise.
The purpose of this post was to highlight the disparity between recent economic data and the markets' assessment of the US economy. The argument from traders will be that markets are forward looking while the data is backwards looking. Once the data starts to reflect the stronger economy the market is anticipating, the gains will be made and it will be time to sell. Another factor is that recent data may be deceptive because of the effects of businesses adjusting due to the uncertainty of the fiscal cliff.
Those bearishly inclined will assert that this rally is built more on central bank liquidity than fundamentals so it is only a matter of time before it comes back to reality. There are memorable moments when the market was spectacularly wrong in its assessment. Many of these are permanently embedded in our minds. These times were characterized by bubble-like conditions in which rising prices begat rising prices and issues trade purely on emotion. I do not think this is one of those times, but the answer will only be clear in some time.
Briefly reviewing past disparities, it seems as if this divergence can persist for quite some time. There were instances in which the data caught up with the market and other times in which the market came back to Earth as the data kept getting worse. Currently, I think we should give the market the benefit of the doubt due to other bullish factors such as liquidity and breadth detailed in this article. However, I will be continually monitoring the data as it is necessary for a continued rise. In a future post, I would like to go in depth into these time periods to see what lessons can be applied to the current divergence.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.