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The Dow Industrial Average (DJIA) closed at 13,580 points last week, up by 11% YTD, marginally below its peak in October 2007 when it traded at 14,160 points. Similarly, the S&P 500 (SPX) went up 30% from where it was a year ago. However, what has confused most stakeholders is the Dow Transportation Average (DJTA), which has hardly moved this year; this is in direct contradiction to the Dow Theory. The upward movement of the SPX and DJIA, with a stagnant DJTA, is referred to in the Dow Theory as bearish divergence. What needs to be decided is whether the economy will follow the Dow Theory, and stocks will tumble to converge with the DJTA, or whether the long-held theory will be violated with the economy entering the third phase of Quantitative Easing?

click to enlarge images

DJTA, DJIA and SPX

*INDU:IND = DJIA

*TRAN:IND = DJTA

*SPX:IND = S&P 500

The table given above depicts a very incoherent story. Historically, the transportation sector follows an early cycle. By this we mean that goods are transported before the economy picks up. Therefore, the transportation index moves closely with the Industry average, as well as the SPX. However, this year, the situation has been a bit different. The SPX and DJIA, which are considered to be important indicators of economic growth, have picked up in almost double digit growth figures. However, the DJTA, an indicator for the Transportation Industry, shows that the industry declined this year.

The Dow Theory tells us that if one of the averages i.e. DJIA and DJTA, moves upwards and the other remains stable/stagnant, then the upward moving average is just a product of market inefficiency and is bound to come down as the market corrects itself. Therefore, it presents a bearish case. That is probably why many mutual funds have withdrawn their investments after making double digit gains this year. Benjamin Pace, the chief U.S. investment officer for the Private Wealth Management Wing of Deutsche Bank (NYSE:DB), joked with his colleagues that they should take the rest of the year off.

However, there is a bullish point of view as well, which suggests that since the Fed has decided to throw $40 billion every month into the economy till it recovers from the slowdown, money from bonds will likely be diverted towards riskier investments like stocks. Therefore, the rally may not end at all, and it might be the DJTA that needs to be corrected, not the DJIA.

There is yet another point of view that states that the DJIA hardly contains transportation stocks now, as compared to having more than 90% in its basket when the index was formed. Currently, only three industrial stocks are part of this index. The rally might be because of the tech stocks or the surge in healthcare stocks. Therefore, it may not at all be representative of the industrial sector, and may not be correlated to the activity in the DJTA, which is formed of railroads, airlines, truck transporters and truck lessers' stocks. Also, industrials form hardly 10% of the overall SPX.

Transportation Sector

The transportation sector, when viewed in isolation, gives a bearish outlook. Airlines have seen tough times due to rising oil prices. Although oil futures traded at six-week lows last Friday, from which airlines like US Airways (LCC), Delta Airlines (NYSE:DAL) and Southwest Airlines (NYSE:LUV) benefited, the prices are expected to rise given the uncertain geopolitical situation in oil rich areas like Iran and the rest of the Middle East.

Truckers have hardly seen any improvement in freight rates or volumes for this year. The improvement has only been brought about by managing the cost part of the equation, much like JB Hunt Transportation (NASDAQ:JBHT) and Conway (NYSE:CNW) have.

Recently, Norfolk Southern (NYSE:NSC) cut its guidance a day after UBS and Credit Suisse (NYSE:CS) downgraded the whole Railroad Industry, given the weak outlook for coal and grain. All railroad stocks like CSX Corp (NYSE:CSX), Kansas City Southern (NYSE:KSU) and Union Pacific Corp (NYSE:UNP) suffered as a result. Carloads is the favorite economic indicator of Warren Buffett. The recent-most data released on carloads showed that they are down 2.4% YoY.

The Baltic Index has moved up by almost 10% in the last week. However, it is still down 57% YTD. The improvement is not guaranteed to be sustainable, as it can be merely because of the recent approval given by the Chinese government to spend $157 billion for infrastructural development in the country.

Let us not forget that economic bellwethers FedEx (NYSE:FDX) and United Parcel Services (NYSE:UPS), in their latest earnings releases, slashed their future outlooks, showing that a weak economy is awaiting businesses in 2012 and 2013.

Conclusion

Transportation is the only link between manufacturers and consumers of goods. Even online buyers depend on FDX and UPS for their deliveries. In short, industrials make and transports take. If transports are not taking, what is the purpose of industrials making anything? The Dow Theory suggests that there is economic weakness, and the market will sooner or later adjust to show the real picture, as transporters are having a tough time, whereas the Dow Jones Industry Average is near its 5-years high. What will be important to see will be whether QE3 will be effective enough to pick up the transportation sector, or will it fail, thereby meaning that U.S. economy will witness yet another collapse.

Disclosure: The article has been written by Qineqt's industrials analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.

Source: Bearish Divergence: Has Dow Theory Failed?