Is Dow Theory Signaling Future Stock Market Declines?

Dow Theory is a heavily followed stock market indicator. The century-old theory stipulates that for a bull market to be sustainable, any rally to new highs in the Dow Jones Industrial Average must be accompanied by a new high in the Dow Jones Transportation Average.
Transports are companies involved in industries such as railroads, trucking and airlines. If the transports don’t rally alongside the 30-stock Dow Jones Industrials benchmark, broader market declines may soon follow.
Dow Theory is in the news right now, because the transport index is down approximately 10% since its all-time high, reached in late December 2014. This has stoked fears that the stock market as a whole is due for a decline, as airline and railroad stocks have been some of the market’s worst performers in 2015.
Indeed, several industries within the transports are flashing warning signs. For railroads, the worry is that the U.S. economy may be slowing down. Last quarter, earnings results were downright ugly from a number of railroads, including Norfolk Southern (NYSE: NSC) and CSX Corp. (NYSE: CSX).
Norfolk Southern’s earnings per share fell 14.5% and badly missed analyst expectations. CSX’s revenue was flat last quarter on a year-over-year basis, but its shipment volumes were concerning. Agriculture volumes fell 1% year-over-year, as a result of weaker agricultural exports. And like Norfolk Southern, coal was a problem as well. CSX saw a 1% decline in coal volumes.
Airlines are also struggling. After a period of significant stock price gains fueled by lower oil prices, airline stocks are giving back a lot of those advances, as oil has rebounded about 30% off its 2015 low. Analysts are now worried about pricing and flight capacity, on similar fears of a U.S. economic slowdown, which could result in lower airline traffic going forward.
This was the catalyst for American Airlines Group (NYSE: AAL) cutting its forecast for current-quarter unit revenue and pretax margins. Meanwhile, competitor United Continental Holdings (NYSE: UAL) is down 20% year-to-date.
There is good reason for investors to consider the decline of the transport index as a harbinger of things to come. Railroads, airlines and trucking companies are widely viewed as bellwethers for the broader economy. These companies are involved in transporting a host of goods throughout the country, across several different sectors.
As the popular thinking goes, if the transports are in trouble, it will soon ripple across the rest of the stock market.
However, it’s worth noting that Dow Theory is not a perfect predictor of future stock market performance. While airline and railroad stocks are declining, it should be kept in mind that these companies are still highly profitable. This has made their stocks cheaper, but since their underlying fundamentals are still intact, value investors may step in and buy these stocks on the cheap.
Airline stocks widely trade for less than 10 times earnings. United Continental and American Airlines, for example, each trade for about 9 times trailing earnings per share.
And many transportation stocks are strong dividend payers as well. The railroads are a particularly good source of yield. Norfolk Southern and CSX yield 2.6% and 2.1%, respectively – both of which exceed the average yield in the S&P 500 index.
Ultimately, Dow Theory is a valuable predictive tool, and the underlying reasons for the Dow transports’ declines should be a concern to investors. With stock markets near record highs, economic growth in the United States leveling off, and the prospect of higher interest rates on the horizon, it’s reasonable to think stocks are in for a disappointing finish to 2015.

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