Back in 1999, when the Nasdaq was going parabolic in what would be its last hurrah, the market was sending clear signals that all was not well. But you had to look beneath the surface to find them. There were technical divergences building up (declining market breadth, etc.), and also some key indexes like the Dow Transports that failed to participate in the continuing rally.
According to the Dow Theory, when the Dow Transports begin to lag the Dow Industrials, it is a significant event. This divergence signals that not all of the market agrees that the future is full of blue skies and sunshine.
In May 1999, both the Industrials and the Transports made new highs. But from that point forward, the Dow Transports declined and continued declining, even while the Dow Industrials rallied to a new high in January 2000.
Back then, almost no one trusted the “sell” signals issuing from the Dow Theory. Instead, almost everyone talked about how the “New Economy” was impervious to things like the business cycle, an inverted yield curve, and – especially – an antiquated stock-trading theory based on the Industrials and the Transports. I mean, how 20th century could you get?!
Despite all that, it wasn’t long before the Nasdaq peaked in March 2000 and the bear market began. Looking back, all the signs were there for those who wanted to remove their blinders: The yield curve had inverted, there was a Dow Theory divergence between the Dow Industrials and the Dow Transports, and the rally into the 2000 high had become very narrow and concentrated in a relatively small number of stocks (i.e., market breadth had declined significantly).
Fast-forward to today, and we have many of the same market conditions – albeit on a smaller scale. The yield curve has been inverted for over a year. Since the high in July, the Dow Transports have failed to follow the Dow Industrials to a new high and instead have languished near their lows.
Market breadth on this advance has been poor. In fact, we have an enormous divergence between some parts of the market that have rallied to new highs and other more economically sensitive parts of the market that have not followed.
This divergence often occurs at the beginning of a downturn, which is why we suggested put options the Transports in last month’s issue. We now have short positions in the weakest areas of the market – the financials, the Transports, and the home-improvement sector. Even if market indices like the Dow continue to make new highs, these sectors are likely to remain very weak, and could easily lead the rest of the market to the downside.
The weakness of the Dow Jones Transportation Average is not merely a technical divergence, however, it is also a fundamental sign that the economy is struggling. As the nearby chart clearly shows, there is a reduced demand for trucking. Coming out of the 2001 recession, shipments increased until 2005, then declined throughout 2006 and so far through 2007.
Supply Chain Digest is also reporting that inbound container volume growth has slowed dramatically at US ports over the past year, with May 2007 traffic down 0.2% from a year earlier. This confirms the slowdown we are seeing in truck tonnage, and also suggests the consumer-led economy is slowing.
Net-net, it’s time to short Dow Transports. Here are six reasons why:
- Housing has clearly stalled and shows no sign of recovery. With mammoth numbers of ARMs resetting between now and March 2008, things can, and likely will, get much worse. Shipping material for new construction will continue to weaken.
- Shipping needs to furnish new homes will also continue to weaken.
- Commercial real estate is poised to fall. Deals are collapsing as “people who can get out are getting out”. The rate of increase of building new stores, as well as the merchandise required to fill those stores, will fall. That clearly means reduced shipping demand.
- A weakening job market means less consumer demand. And falling consumer demand means fewer items need to be shipped.
- Credit card defaults are rising. One reason is the housing ATM has been shut off. This is an ominous situation for cash-strapped consumers, who will be forced to cut back on purchases of stuff they do not need at prices they cannot afford.
- Until recently, truckers have been able to pass on rising fuel costs, but that has changed in the face of falling demand.
The key thing to remember about avoiding a downturn in stocks is that by the time everyone realises a bear market has begun, it will be too late to do anything about it -because stock prices will have already declined. When the Fed began its rate-cutting campaign in January 2001, stocks rallied on the belief that the Fed would rescue the market. But only two months later, the S&P 500 was down 20%, and over the next year and a half, the S&P lost over 40%. You have to prepare ahead of time, when everyone is still convinced that everything is fine.
There is very little chance we will see another bear market like the 2000-2002 bear market again in our lifetimes – those come around only once every couple of generations. But an “average” bear market is certainly possible over the next year, especially given the housing situation and the market action we’re seeing. Since the end of World War II, the average bear market has taken stocks down a little over 25% in a time span of 10-12 months. Certainly nothing to sneeze at, since it would take a gain of 33% from that low just to get your portfolio back to even.
So enjoy the rally while it lasts, but keep a very close eye on the Dow Transportation Average.
Mike Shedlock and Brian McAuley
for The Daily Reckoning Australia