Transportation Indexes And ETFs Should Be Broadened

| About: iShares Transportation (IYT)

Investors are familiar with the Dow Jones averages: Industrials, Transportation, Utilities and Composite. Standard and Poor's boasts four similar indices, plus a fifth: Finance. Millions of analysts and stockholders use these guideposts to influence their investment decisions.

What do these industry categories mean, and why are they important? The idea of market "averages" is credited to Charles Dow, one time editor of the Wall Street Journal and originator of the theory that bears his name:

  • Industrials were shares of companies that produced goods. Back in Charles Dow's day (the 1890s) this meant manufacturing, steel companies, and other producers of tangible goods. In our contemporary economy, it increasingly means wielders of services, like IBM (NYSE:IBM) or The Travelers Companies (NYSE:TRV).
  • Transportation originally meant railroads. It's hard to find an old market wag who remembers when this Dow Average was called the Rail Roads (two words). Now included in the Transports are ocean shipping companies, as well as airlines and parcel delivery services like United Parcel Service (NYSE:UPS) or FedEx (NYSE:FDX).
  • Utilities is one category of stocks that has changed little over the past century. These companies provide the power and fuel that enable other companies to run: gas, water, and electricity.

Composite Indexes consisted of the firms in all 3 categories and were designed to measure performance throughout the entire economy. Relatively few analysts use the Dow Jones Composite; for most investors the S&P500 Composite is the benchmark to which their performance is compared.

Even given their grip on the financial news media and public, it is easy to underestimate the importance of these Indexes. Trillions of dollars throughout the world use these measures to assess the economy's health, change their bullish or bearish posture, and shift from one market sector (or one individual stock) to another based upon performance or lack thereof.

Which leads me to the following question: What if these measures were seriously flawed? What if, for the sake of this article, the Transportation Index was not truly a good measure of how this sector of the economy performed?

When I taught environmental science and economics in college, I always tried to impress upon my students the importance of measurement. All Scientific endeavor begins with measurement. For example, no matter what one's opinion is about the science behind Global Warming, there can be no discussion about the subject at all unless we are properly measuring temperatures. If one analyst talks Centigrade, and another Fahrenheit, confusion will reign. (Except at -40 degrees. Solution is left to the reader).

Think I am joking? I'm not. Back in 1999 a $125 million dollar weather satellite destined for Mars was destroyed upon arrival at the Red Planet because some project engineers used Metric units of force and others used the old British system. And these are engineers, folks: pencil necked geeks who are supposed to be too smart to do such a thing. But hundreds of millions of dollars and man hours were lost.

Similarly, if a widely used Transportation Index like the Dow, or its tracking ETF, the iShares Dow Jones Transportation Index ETF (NYSEARCA:IYT), does not measure how our transportation sector is doing, billions of dollars can be lost or mistakenly allocated.

It is my belief the Transportation Averages (there are several, as I've made clear) do exactly that.

How so? Lets look at the two biggest Transportation Averages:

  • The Dow Jones Transports. For the sake of brevity, this average consists of two marine shippers, five airlines, four railroads, four trucking companies, and five delivery and logistical services firms.
  • The Standard and Poor's Transportation Index. This index contains more companies (forty, instead of twenty like in the Dow) but the industry groups are exactly the same.

What's missing? Think more carefully what we mean when we say "transportation" company. It is a company which does not own, or manufacture, anything but merely transports items from place to place. Does FedEx own the Christmas packages it is moving right now? Does Alaska Air Group own its passengers and their luggage? Does a railroad own the coal or the oil which they ship? Of course not.

Therein lies a hint, and one large oversight in all Transportation Indexes I am familiar with. They do not include companies which transport oil and natural gas. While many of these companies are limited partnerships, such as Kinder Morgan Energy Partners (NYSE:KMP), they are actively traded on exchanges like the NYSE and elsewhere. Thus I suggest several changes be made to make Transportation Indexes more representative of the industry as a whole, and more informative to investors:

  • First, shares in oil and natural gas pipelines and carriers should be included in these indexes. They are not in any index or ETF that I know of, and most certainly not in either the Dow or S&P Indexes. Maps of the pipelines carrying these vital fuels resemble the interstate or railway network in their extent!

Companies like FedEx, frantically shipping Barbie Dolls to young ladies around the country in time for this Christmas, are counted as transportation. But companies which ship the oil and gas which fuel our economy, and almost every other business, are not?

  • In a broader context, I argue that companies that ship goods and services online should also be listed and measured by Transport Indexes. By this I don't mean an (NASDAQ:AMZN): when they ship goods, they use FedEx or airlines, and thus the transaction is captured. But what about a company that sends software or graphics online over electronic and optical networks? This means that AT&T and Verizon are transportation companies. After all, if businessmen gather in Chicago for a conference, they may fly, rent a car, or take a train. But if they gather online, share ideas, look at product prototypes, ideas and products are not being moved around? Of course they are! If I download software, it is being sent to me as surely as if I ordered the disk delivered by UPS!

This idea is not as crazy or original as it sounds. Back in 1890 when Charles Dow started the Transportation average, along with rail roads and a marine shipping company, he included...Western Union. That goes to show just how farsighted Dow was.

In fact I would argue that any company that does business primarily through the internet... Netflix, for example, uses the transportation network of our 21st century: phone, fiber optic, and satellite transmission.

Such an oversight has serious consequences for investors. One narrow example is the hand wringing over the Dow Jones Transportation Average not "confirming" recent bull market strength. If companies like AT&T and Verizon were in that average, their price strength earlier this year would have helped pull the Transports out of their funk. The oil and gas partnerships might have done the same. Certainly the iShares Dow Jones Transportation Average Index Fund ETF would be a much better performer.

In a broader context and returning this article back to its starting premise, neglecting 21st century "transportation" stocks means that these indexes misrepresent - specifically, understate - the performance of this vital sector of the economy. All kinds of decision makers, from politicians in Washington to mutual fund/ETF managers, to individual investors, are misled by this error. Investing is difficult enough without of standards of comparison being flawed. Furthermore, I suggest it represents a marketing tool for ETF managers who want their portfolios to give investors the opportunity to profit from growth in this broader sector.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in IYT over 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.

Additional disclosure: I encourage readers to suggest other companies that are "overlooked" transportation firms.

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