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Many of the basic tenets of technical analysis can be traced back to “Dow Theory,” which was first developed by Charles Dow (of Dow Jones fame) in a series of editorials published in The Wall Street Journal. These ideas include the principles that the indexes discount the news and that market trends require confirmation.
Specifically, Dow Theory considers a breakout in a broad index (like the Dow Jones Industrial Average or S&P 500) confirmed if transportation stocks have also broken to new highs. If you think about it, this should make sense: if large industrial firms are growing (especially during Dow’s day), then the transportation companies that ship goods and commodities to and from the industrial firms should also be growing.
If the indexes aren’t confirming each other, the potential for a “fakeout” increases. New lows in the transportation index while the S&P 500 was continuing to rise in early 2015 was an important warning of the upcoming volatility that year.
Although the dominance of the industrial sector has waned in the subsequent 120 years since Dow Theory was developed, I think transportation stocks still provide important confirmation for a strong bullish rally in the S&P 500. The U.S. economy is mostly driven today by personal consumption, but goods and services are still shipped and transported to consumers.
At this point, neither the S&P 500 nor transportation indexes have broken to new highs, so we haven’t experienced a confirmation signal like we did in November 2016 or January 2013 prior to those dramatic rallies. However, I think we can still use transportation stock performance to provide a heads-up as to when momentum is more likely to strengthen.
Norfolk Southern Corporation (NSC) gave an investor presentation today showing how the rail company would reduce its operating ratio to 60% by the year 2021 through a combination of technological efficiency, capital investment and cost reductions (reducing headcount). The operating ratio is the percentage of revenue allocated to operating expenses and is a standard measure for transportation company efficiency. Another way to think about this is that the railroad company is trying to increase its operating margin (operating income/revenue) to 40%.
Investors liked what Norfolk Southern’s management had to say, and the announcement had a “halo effect” on other stocks in the industry. In fact, as you can see below, the S&P Road and Rail sector has closed at a new short-term high today. While this isn’t fully representative of the entire transportation sector, it’s a positive sign that investors are pricing in more growth opportunities in the market.
Bullish momentum in a key sector like transportation is important while the S&P 500 continues to consolidate near its 61.8% retracement level. Part of the problem with the tariffs is that much of the increased costs are borne by consumers. Beginning next week, the pace of earnings reports from consumer stocks will increase significantly, which increases the risk that the outlook for first quarter earnings could be reduced again if the trade situation is expected to worsen. A continued rally in transportation stocks could do a lot to offset potential bad news in earnings.
Risk Indicators – USD Double Bottom
Although I have focused on this a lot over the past two weeks, the U.S. dollar’s continued run to the upside is becoming a greater concern. The dollar index rallied again today against most of the majors in the forex. The Invesco DB US Dollar Index ETF (UUP) has now completed a short-term double bottom pattern that has an upside target equal to the prior highs from last December.
In previous issues of the Chart Advisor newsletter, I pointed out that a stronger dollar discounts the profits earned by U.S. multinationals, but there are other issues as well. A stronger dollar makes U.S. exports less competitive because they are more expensive in foreign currency terms. The inverse of that problem is that imports to the U.S. are less expensive in U.S. dollar terms because a stronger dollar can be exchanged for more of a weaker foreign currency.
A stronger dollar stunts exports and stimulates import growth in the short term, which worsens the U.S. trade balance. In my view, the recent data on the U.S. trade balance has the potential to complicate trade negotiations, even if China’s trade policies are not completely to blame. The stronger the U.S. dollar becomes, the more challenging trade negotiations will be – that could send investors into another tailspin.
Bottom Line: Could Be Another Slow Week
Almost all risk indicators (besides the U.S. dollar) remain calm despite troubling headlines about trade with China. This leads me to conclude that volatility is still biased to the upside if the market starts to see good news on trade and earnings. However, compared to the rest of earnings season, this week is a little light on news until Thursday, when the Census Bureau releases retail sales for the month. More aimless trading until Thursday (and potentially into next week) shouldn’t be alarming, and many traders may be looking for dip-buying opportunities if there is some short-term volatility.
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