How to Get a Contrarian “Leg Up” on the Market

Despite the market’s strong rally since mid-summer, many investors remain cautious due to multiple conflicting signals from market internals — chief of which is the non-confirmation of the Dow Theory.

The Dow Theory basically says that a bull market is confirmed when all three major Dow Jones Averages — Industrial, Transportation, and Utility — make new highs. But while the Industrial Average has made new highs for the year, neither the Transportation Average nor the Utility Average have confirmed the new highs, a traditional bearish divergence.

However, between the two underperforming Averages, Transportation is now of greater concern. When the transportation sector is underperforming, it has historically been a signal the economy is weak, which is normally bearish for stocks.

Click the chart for a larger view.

If you think about it, it generally makes sense …

When the economy is getting stronger, goods are moving from factory to consumer, contracts are sent next day air, freight is being shipped via rail, truck and vessel, and business travelers are flying to close deals.

But while the popular DJIA moved to new highs for the year just last week, the Transportation Average lagged. I’m normally a very big fan of looking at anecdotal evidence across sectors to try to gauge market direction, which is what Dow Theory does. However I’m not convinced that transportation stocks are necessarily giving the troublesome signal their underperforming index is indicating.

When looking at any index to see if it’s indicative of the broader macro-economic environment, the first thing you need to realize is that the index is a collection of individual stocks — their collective performance is the index’s performance. Sometimes, in order to understand why an index is outperforming or underperforming, you have to go in and look at individual stocks’ performance and their weighting in the index.

Railroads Pulling the Index Down

The Transportation Average is a price-weighted index. That means the stocks in the index with the highest share prices are the most heavily weighted, and as a result affect the index the most. In the case of the Transportation Index, many of the most expensive stocks are railroads. And railroads have badly underperformed the market since May.

A big reason for railroads’ underperformance has been reduced shipments of coal, which is a major source of revenue for them. Coal shipments have been declining not because the economy is plummeting, but because of increased regulation from Washington. Moreover, natural gas prices have fallen like a rock over the past few years, which have caused power plants to switch from coal to natural gas as their input fuel.

Falling coal orders have hurt the railroads.

Those reduced coal shipments have led to lower revenues and lower share prices for railroads. And that at least partially accounts for the transportation sector’s underperformance.

Now, I’m not saying you should totally dismiss the Transports’ weak performance. But instead I’m just trying to point out that as an investor, you have to look beyond the obvious conclusion and see why an index is underperforming or out performing, and if there is an investment opportunity in it.

One way you could play this is by looking at stocks other than railroads that are in the Transportation Average.

Or you could wait for a potential recovery in the transportation sector when the economy picks up and buy the iShares Dow Jones Transportation Fund (IYT). This exchange traded fund seeks to duplicate the performance of the Dow Transportation Average and owns shares of companies such as Union Pacific, UPS, and Norfolk Southern.

Looking at various averages for confirmation of a market move is an old trick many professional traders use. But just be sure you know why the averages are acting the way they are by understanding the underlying components. If you do that, you can generate insight that can give you a contrarian leg up on the market.

Best,

Tom