Are The Transports Sending A Bearish Signal?

by: Clif Droke

Dow Transports post worst 8-day performance in 10 years.

Some analysts believe this is the preliminary to a market-wide decline.

Fundamentals and technicals don't support this conclusion, however.

As the major stock market averages have paused near their November 2018 highs, a somewhat disturbing development is taking place under the radar of most investors. The Dow Jones Transportation Average (DJTA) has posted its worst short-term performance in 10 years, prompting some concern among technically-oriented traders. In today’s report, we’ll take a close look at the Dow Transports and discover that while the Transports are creating a drag, the market’s internal and fundamental strength should allow it to shake off this temporary weakness and continue its recovery this spring.

The ever-vigilant bears have found something new to worry about. The Dow Jones Transportation Average has just posted its longest stretch of consecutive losses since 2009, according to FactSet. This was enough to cause a flurry of discussion in various online financial circles, especially among proponents of the Dow Theory.

Serving to cushion this seemingly bearish statistic is that fact that the latest DJTA pullback has been the shallowest since 1990. While the Transports have shed 3% in the last eight sessions, the Dow Industrials have lost less than 1% since Feb. 21 (as of March 6).

Nevertheless, there is a disconcerting historical implication to the DJTA’s 8-session loss. A March 6 MarketWatch article highlighted this potentially bearish signal:

The last time the Dow Transports fell for eight straight sessions, the Dow Industrials shed nearly 7%. Moreover, during a lengthier 10-session skid for transports that ended Feb. 23, 2009, the Dow Industrials declined by about 14% over the same stretch.”

While the extent of the DJTA’s recent pullback has been small, there’s no denying the Dow Transports have lagged the Dow Industrials recently. This, more than anything, has been the reason for the concern. Shown below is a graphic comparison of just how much the DJTA has failed to keep pace with the Dow Jones Industrial Average (DJIA) in the last couple of weeks. This is what has some Dow Theorists concerned, for classical Dow Theory states that when the Transports fail to confirm a rise in the Industrials, there is reason to question the strength of the rally.

Dow Jones Transportation Average vs. Dow Jones Industrial Average Source: BigCharts

It should be noted, however, that all but one of the DJTA’s individual components are up for the year to date. A more important observation is that the Transports have largely kept pace with the Industrials since the December 24 bottom (see chart below). This, more than anything, is a reason to dismiss the short-term under performance in the Transportation stocks as a case of the bears trying too hard to paint a negative picture for stocks. Only if the DJTA accelerates the recent decline and widens the gap between it and the Dow Industrials will there be a cause for concern.

Dow Jones Industrial Average vs. Dow Jones Transportation Average

Source: BigCharts

What is likely happening right now with the Dow Transports is now starting to be reflected in other major indices. The benchmark S&P 500 Index (SPX), for instance, closed under its 15-day moving average on Wednesday (below). This marked the first time this year that the SPX has violated its 15-day MA since technically confirming a bottom in early January by closing two days above the trend line (per the rules of my trading discipline). Normally, a closing violation of the 15-day MA after a long rally signals that the market’s upward trend has temporarily exhausted and is in need of a resting and repair period. There’s no predicting how long, or how deep, the latest pullback may be. But based on current internal conditions, it’s more likely to be a “pause that refreshes” and another “buy the dip” opportunity than an outright reversal of the recovery.

S&P 500 Index

Source: BigCharts

If the market was setting up for another major selloff, it would almost certainly show up in the NYSE breadth and volume indicators. The NYSE advance-decline (A-D) line shows no signs of distribution (i.e. informed selling) taking place as of early March. Instead, this important indication of market breadth shows that most stocks on the Big Board are still rising in concert with no signs of divergence among the key sectors. Ordinarily, a sharp downward trend in the A-D line would precede a significant setback in the major indices.

NYSE Advance-Decline Line Source: StockCharts

The NYSE advance-decline volume indicator has also shown no sign of distribution taking place below the market’s surface. What this indicator (below) is saying is that there is still more upside than downside volume, which is constructive for a “buy the dip” opportunity.

NYSE Cumulative Volume Source: StockCharts

Meanwhile, my favorite gauge of the stock market’s near-term health hasn’t yet flashed a sell signal and is still bullish. I’m referring to the 4-week rate of change of the NYSE new 52-week highs and lows. If the bears were truly in control of the stock market right now then we should see a notable spike in the number of NYSE-listed stocks making 52-week lows (e.g. more than 40 new lows for several days). This would let us know that internal selling pressure has definitely increased enough to create a negative undercurrent for the broad market and would therefore make it easier for sellers to push the major averages lower. Also, we should see the new 52-week lows outnumber the new highs for a few days to confirm a weak market. This hasn’t happened yet.

Source WSJ

On a fundamental note, while there is continued talk in certain quarters of an “earnings recession”, the evidence from the latest earnings season still supports the continuation of the broad market recovery which began in December. The blended earnings growth rate for the S&P 500 during Q4 2018 is 13.1%, according to FactSet. This puts the index on track for the fifth consecutive quarter of double-digit earnings growth. Although analysts are predicting below-average earnings in the upcoming quarters, this negative sentiment is likely a reaction to the 20% plunge in the SPX late last year. The long-term S&P 500 forward earnings and revenues trends, meanwhile, are still supportive of this bull market.

The composite picture of corporate fundamental strength and internal strength should allow the stock market to continue its recovery this spring once the latest pullback has ended. The odds are that investors will have a “buy the dip” opportunity this month rather than a confirmed sell signal. As long as the above-mentioned indicators remain firm, investors also shouldn’t be worried about the latest weakness in the Dow Jones Transportation Average.

On a strategic note, investors should be long the sectors and industries which are showing the most relative strength and solid fundamentals. In particular, investors should be looking at consumer staples, pharmaceuticals, and real estate equities, as well as the tech sector in general. I also recommended that technical traders maintain a long position in a market-tracking ETF, such as the Invesco S&P 500 Quality ETF (SPHQ), of which I'm currently long.

Disclosure: I am/we are long SPHQ, XLE, XLF. 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.