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By Amber Yuan

The Dow Jones Transportation Average (DJT) may not show up on The Wall Street Journal's front page, but it is an extremely helpful tool for investors. Created in 1884 by Charles Dow, the DJT is the oldest of the U.S. stock indices. Its more popular counterpart, the Dow Jones Industrial Average, was created 12 years later. The original DJT consisted of nine railroad and two non-rail companies, but as modes of transportation changed over time, so did the companies that constitute the DJT. Currently, the DJT consists of 20 companies from industries such as airlines, trucking, railway, and delivery. You can find popular names such as Southwest Airlines (NYSE:LUV) and FedEx (NYSE:FDX) on the DJT, but lesser-known companies such as marine-transportation provider Alexander & Baldwin (NYSE:ALEX) are on the index as well. Of the 11 original companies on the DJT, only Union Pacific (NYSE:UNP) - think Promontory Point and the Transcontinental Railroad - remains. As an investor, the most important takeaway from the DJT is its connection to the DJI.

*Market data is obtained from Yahoo! Finance
(Click to enlarge)

*Market data is obtained from Google Finance

What you notice [in the above graph] is that the direction of movement between the two indices is almost identical. Sure, you can say that the S&P 500 confirms the movements in the DJI because those two generally move together, but the DJT can be uniquely used to predict movements in the DJI - an idea commonly known as the Dow Theory. (The entire Dow Theory was developed by Charles Dow in the late 1880's through a series of editorials in The Wall Street Journal and cover more broad concepts that explain stock movements in general, but this term has come to commonly refer to the relationship between the DJT and the DJI).

So how do you interpret Dow Theory as an investor? When the DJT increases, you can expect to DJI to follow suit. Think about it this way. The transportation industry uniquely affects almost all other industries covered in the DJI. Companies such as Wal-Mart (NYSE:WMT) and the Home Depot (NYSE:HD) on the DJI rely on transportation shipments to stock their stores, companies like Caterpillar (NYSE:CAT), Coca-Cola (NYSE:KO), and IBM (NYSE:IBM) use transportation throughout their manufacturing process, and companies like Exxon (NYSE:XOM) look to demand from transportation companies to maintain their performance. When companies anticipate a positive performance, they will increase production of goods that need to be transported between different stages or production, increase orders of good that need to be transported to the consumer, or both. Because companies buy contracts in anticipation of future transportation needs, anticipated increased production translates into a real increased demand for transportation contracts. Transportation providers can then bid for higher contract prices, making their own outlook more positive and causing the DJT to rally. At the same time, the anticipated outlook of the transportation industry's customers is reflected in its stock prices and the performance of the DJI follows the DJT. Let's look at a more specific example of how to use the DJT as an investing tool. This is data from the first three months of 2012.

*Market data is obtained from Yahoo! Finance
(Click to enlarge)

*Market data is obtained from Google Finance

For the most part (January, March and the beginning of February), the DJT and the DJI followed the same trend, but notice the divergence in the two indices toward the middle of February. Around this time the DJI passed 13,000 for the first time since the financial crisis, but despite gains in the DJI, the DJT actually shrank. Thinking of this divergence in the movements of the DJT and DJI indicate from an investors' point of view, you should expect the DJI to follow the DJT. That is exactly what happened as the DJT failed to hold the rally. Investors believed the market was oversaturated and that the stock market was an inflated outlook on actual economic growth (think real industrial indicators like the DJT), and the DJI dipped below the landmark 13,000 as a result.

Last week, the DJT's negative performance has been reflected in the DJI's losses. Both indices moved in negative directions on lackluster employment reports, with the number of jobs added into the economy during March at 120,000 instead of the predicted 200,000. You can expect demand for transportation contracts to be down during this period of time as many companies are placing less orders for transportation over uncertainty of their future performance. Indeed, this uncertainty translated into losses for transportation companies looking for contracts and also losses in the company stock.

So the next time you check where the DJI stands, make sure you check the DJT as well. If the DJI is up but the DJT is down, shorting an ETF in the DJI might be a good investment decision.

Source: Using The Dow Jones Transportation Average: A Smarter Way To Invest