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September 01, 2006

What Are The Transports Telling Us?

What Are The Transports Telling Us?...It's pretty darn clear that the markets reacted relatively meaningfully to a good number of 2Q earnings announcements, both on the upside and downside. And certainly one sector feeling a bit of surprise and pain in spots as of late has been the transports. We thought it worthwhile to spend some time looking at the group as the transports, at least in our minds, are important on a number of very meaningful fronts. First, as we're sure you are fully aware, the transports are a key component of Dow Theory for theory enthusiasts far and wide. And at least as of late, the Transports and headline Dow have been moving in completely opposite directions. From a Dow Theory standpoint, this screams "watch me". As we're sure you are also aware, in contrast the Dow Utility average, another key component of Dow Theory, has recently run to all time highs. The financial markets are never easy to figure out, now are they? (Of course that's because they are driven by human decision making and that's what keeps the markets ever fascinating.) From our point of view, another reason that the transports are quite important to keep an eye upon at present relates directly to the US consumer and the overall global economy. A global economy relatively meaningfully dependent on that very same US consumer. If indeed we can believe that the financial markets are always looking ahead and discounting events yet unseen by the human eye, a serious technical breakdown in the transports is a message we need to be accepting of and ultimately translate into our own investment actions. A serious transport index breakdown could be pointing directly at a domestic, and most probably global, economic slowdown of substance to come. You'll remember that last month our discussion centered solely on residential real estate and how the cycle can and does influence the real economy. Of course as of late the mainstream press is literally filled with attention to recent, and not fun, housing data. What seems to have been neglected in recent months is the damage being done in the transport sector. Let's get right to it and hit the highlights as we see them.

First, the obligatory daily chart of the transports stretching back a little over a year and one half. As of late, we've seen a break of the 200 day MA, an effort at a retest, and a subsequent failure. In technical terms, this ain't good stuff. Quite the opposite. Moreover, from a shorter term standpoint, the near double top in May and late June is absolutely crystal clear. Strike two in terms of technical straws piling up on the proverbial camel's back.

But maybe most importantly, and like so many other charts we've noticed as of late, on balance volume (OBV) has broken down very badly. We're showing you the chart above starting in early 2005. The OBV upward trend line has for now been decisively broken to the downside. And into the recent double top in price, both OBV and RSI showed us a big divergence. Although we've only taken this little look back to early 2005 in the chart above, it just so happens that an upward trend line in OBV really going back to early 2003 has been broken as of late. And finally, you can see in the chart the increase in volume on the recent sell off, subsiding a bit as of late. At least from here, technically the transports have a lot of proving to do to get back in gear on the upside as we look directly ahead. First stop, a break of the triangle formation put in over the last few months lies dead ahead.

Before moving forward, let's have a quick peek at some numbers. Just what is moving the total transport index south?

Like many equity indices, the DJ Transport index is top heavy. The top six stocks make up a little under 50% of total index weight. The recent earnings miss by UPS, and sympathetic decline by FedEx, have certainly contributed in a big way to the dynamics of the current technical position of this index. Of course, they were also big contributors on the way up. But as we'll see in a minute or two, current technical weakness is also evident in transport index subcategories, so what's happening in the greater transport index is anything but "company specific". Lastly, three of the brighter price gainers this year are the momentum favorites in the group, CH Robinson, Overseas Shipbuilding and Expeditors. It's not exactly wildly uncommon to see the momentum favorites in a sector be the brightest lights near a major topping area. Forward earnings expectations for the group are anything but reserved or bashful. There is no question that these earnings estimate numbers are in large part based on what has already happened up to this point. Point being, up until now in the current cycle, the transports have been the primary beneficiary of one of the largest global imbalances of the moment - the US trade deficit. The larger this has grown, the better the earnings outlook for this group. And, as you know, the magnitude of the US trade deficit owes its existence to global excess liquidity, the US credit cycle, and the ability of US households up until recently to monetize significant residential real estate price inflation. A sound economic bedrock if we've ever seen one, right? Up until the present, the benefits of the trade imbalance to this group have certainly outweighed the boat anchor of higher energy costs. But that may implicitly be changing if indeed the US consumer is slowing meaningfully, as we believe the case to be.

Another characteristic of the transports we need to keep firmly in mind is that we're convinced hot and hardcore performance oriented money owns the group in a big way. And that means that both setbacks and rallies can be violent. Why are we convinced that hedge, prop desk, momentum, and mainstream institutional money has become involved in the transports in a meaningful way? Look no further than the table below.

And here you thought the small caps were the place to be. The transports have beaten all of the major equity indices since the current macro equity rally began back in early 2003 with the minor exception of the Russell, and this has only now become the case over the last month or so. Hot money involvement is always a whole lot of fun on the way up, but not so much fun on the other side of the equation. As you know, none of the other major equity indices double topped after the May peak, with the exception of the transports. That tells us that on the first price crack after the May top, hot money came right back to the group. Will they be so willing to do so now after having touched the hot stove once? It's an important question that will be answered directly ahead.

So what do we watch in an attempt to try to decipher the "message" of the transport index as we move forward? We have a few simplistic thoughts. First, as you can clearly see in the chart below, literally since the macro equity rally began back in early 2003, the 52 week moving average has been an absolutely key demarcation line for the transports. So far, there have been some quick and very minor violations of this average along the way, but nothing of either substance or longevity. We'll be watching this moving average combined with volume characteristics like a hawk. Unlike anything seen since early 2003, we have experienced a very noticeable expansion in volume with the recent decline, especially down from the double top during July.

The second item we believe is deserving of attention is the monthly chart. Just look at the monthly MACD relationship. Not since early 2003 have we seen this type of histogram weakness. A break to the downside will be a big red flag.

The final item we believe deserving of attention ahead is the performance of the group relative to the S&P. Literally since the macro equity markets topped in early 2000, the transports have been a group that has materially outperformed the broad market (as measured by the S&P). The band of relative outperformance is pretty darn well defined in the chart below.

Here's the deal. And we believe the following comments are applicable to many equity sectors as well as the market as a whole. Very generically, market corrections are really periods where prices change, but sector leadership does not. Leading sectors may experience heart pounding declines, but bounce right back in a continuation process as the macro correction concludes. Meaningful bear markets, by contrast, are periods where we very often experience outright sector leadership change. In our minds, this is a very simplistic rule of thumb. As you know, the demise of tech and the rise of energy and commodities in this decade alone is a perfect example of this phenomenon. The meaningful failure of tech post the early 2000 peak was a preview of a much greater period of difficulty for the entire equity market to come. For now, during the recent correction, we have seen some change in short term leadership. It's clear that money has run to hide in the defensive equity sectors as of now. Tobacco, utilities, staples, some telecom and health care have been key beneficiaries of the need for institutional money to seek shelter from the storm. But, this is not necessarily the result proactive investment management decision making, but rather as a reactive need of institutional equity managers mandated to be fully invested at all times. So, in one sense, the recent rally has been led by "the need to hide", so to speak. Although this may indeed lead to bigger and better things for the equity markets for all we know, it's a structural investment foundation on which few long term bull markets are built. If a true turn higher in the macro equity markets is to occur near term, we'd expect that trajectory higher to be led by small caps, the transports, emerging market equity, etc. - the old leaders. Growth, and ultimately earnings growth, lead bull markets, not defensive posturing. So this is our long winded way of saying that the chart above is quite important. If this trend, which really dates back to early 2000, breaks down ahead, we'd expect big trouble for both the macro equity markets and, by extension, the real economy.

Believing Is Seeing?...As you know, this is one of the toughest parts of dealing with the equity market. Especially in today's world of hedge, momentum and prop desk players, imbibing in the warm embrace of excess global liquidity and dancing between stocks and sectors with frivolity. Because although we do indeed see the technical deterioration in the transport stocks as of late, we do not yet see that technical expression of caution necessarily reflected in the real economy related to the transport sector...yet. We firmly believe that financial markets look ahead and discount forward real world outcomes that most cannot see until they actually come to pass. At that point, the prior movements in equities make perfect sense. But the "from here to there" interim period is always one marked by confusion. We learned many moons ago to throw our investment lot in with what the market is saying as opposed to what the strict fundamental facts of the moment portray. Nonetheless, we hope it's helpful to have a quick look at a few current real world anecdotes that directly reflect US transport sector dynamics.

You may remember that in past discussions we have shown you the Cass Freight indices for both expenditures and shipments. We need to remember that Cass deals with approximately 1200 divisions of roughly 400 companies involved in shipping $50,000 to $500 million in volume each year and handles about $12 billion in processing volumes annually. In other words, they deal with a very wide spectrum of companies using freight services. Below is the current reading for the expenditure index as of June month end. It's almost off the charts, so to speak, albeit down slightly from a record one month back. It's been near vertical up until last month.

One very quick comment about expenditures. As you know, total shipping expenditures necessarily involve energy costs. And you also know that many firms hedge their energy costs far into the future. Is the chart above telling us that many hedges put on years ago are now repricing, if you will, in line with much higher current period energy costs? It's hard to believe that this is not a large part of the reason for the chart looking as it does over the last twelve months. In our minds, what you see above is a double edged sword. It represents strength in that these expenditures are occurring and being supported in the current economic environment, but it also importantly represents shipping costs conceptually moving to a much higher level than anything we have experienced over the last decade and one half. And that has implications for the economy of tomorrow.

Just recently, the shipments index also moved to a new high for this series of data and has just backed down in the latest month. Although we have not indicated them in the chart below, it's clear that large spikes in this index have occurred during periods of excess liquidity being thrown at the global economy. The spike in late 1997 coincides with the Asian currency crisis clean up effort. In late 1998 it's LTCM time. In 1999 and into 2000, it's the Y2K excess liquidity period. And in 2003 and beyond it's the "reflate the global economy, or else" period, courtesy of the US Fed, the BOJ and the People's Bank of China.

At the moment, the Cass Freight indices show us strength in broader transport services. But the equities that represent the group are, for now, saying something much different. Do we believe that the stocks are "telling us" something about potential transportation sector and broader economic weakness to come? Or is recent action simply sector volatility, hot money shifting around, and technical chart driven trading? As we said, this is the tough part. This is where we need to count the cards, so to speak. We need to look for other signs of macro economic slowing to come, to, if nothing else, corroborate the message of the equity market and that of the transports specifically. Our discussion last month on housing was just that.

Lastly, a few views of life from the wonderful port of Los Angeles. As we have spoken about in the past, watching the character of shipping volumes into the greater LA area is quite important in terms of monitoring the US trade deficit and attempting to understand the implications of this volume for the US transportation sector. Maybe most importantly, LA is a huge gateway to trade volumes coming from Asia. Below is the recent data. First, we're looking at the volume of inbound loaded containers, destined for US consumers from sea to shining sea. We can see a recent breakout to a new all time high. We believe the fact that this data has shown us a seasonal range over the last three years has more to do with shipping capacity constraints in the greater Los Angeles shipping area as opposed to mirroring the exact dynamics of Asian trade volume. Like the Cass data, though, no major weakness as of yet.

And finally, maybe a bit more for fun than anything else, the last set of data from the Port of LA is the percentage of deadhead containers leaving the port (empty containers returning home, mostly to Asia). To suggest that US trade dynamics are a bit of a one way street is quite the understatement, no? But we believe the importance of this data below is that it shows us just how important the US consumer is to global trade circumstances and to the US transportation sector.

And this leads us to more of a bottom line comment than not at the moment. If indeed the breakdown in the transports as stocks is sending a message of forward economic trends to come, in our minds they are reflecting a weakening US consumer. Like housing stocks, like many consumer discretionary stocks, etc., the transports may simply be joining the US consumer slowdown recognition party. It seems the way things are going technically for the sector, we're going to know in very short order whether the current breakdown is simply a short term price correction before reaccelerating once again, or a harbinger of both further economic weakness to come and a bona fide Dow theory warning. We believe the charts we have set out above are clear. We need to watch the 52 week MA, the monthly MACD indicator, the performance of the group relative to the S&P, and shorter term price movements in conjunction with volume trends. It's a very good bet that if indeed the equities are telling a story of a future of greater economic weakness, it won't be forever until the Cass and LA Port data start to likewise roll over, confirming the current message of the equities.

Component Warranties?...As maybe a last piece of trying to make sense of the ongoing daily puzzle known as the Dow Transports moving ahead, we can watch the sector components of the broader transport index for signs of corroboration or validation of either weakness or potentially returning strength in the DJTI itself. Believe it or not, it sure appears to us that we are at some very critical technical junctures as we speak. Let's have a look.

The Dow Railroad Index below shows us a pretty darn clear head and shoulders pattern year to date. The neckline of the H&S is the critical point to watch. It's a very close fit with the 50 day MA. The decline to this point has been almost technically classic. A sustained break below the 340 area should be a big warning sign for the broader Dow transport index itself.

The Dow Trucking index has broken below its 200 day MA, and it appears as though the 50 day MA is about to break the 200 day MA to the downside. This index now sits below what was very meaningful support near 330 that looks to now have become very meaningful resistance.

Finally, the DJ Transport Services index is, for now, probably in the best shape of all of the transport component indices technically. Just last week it bounced off of major support near 170, which again also coincides quite closely with the 200 day MA. Admittedly, this index has broken down out of a longer term rising wedge pattern, which is not exactly wonderful. 170 is a must do hold in terms of price level. Below that and we'll throw one more log on the negative technical bonfire when assessing the broader transport index.

Like the homebuilders, like the consumer discretionary issues, and really like the financial services sector (although it has not broken down meaningfully as of yet), we believe the transports are an integral piece of the current total financial market and US economic puzzle. In our minds, the transports have been the beneficiaries of excess liquidity, glaring global trade imbalances, and in good part reflective of a US consumer driven economy that has up to this point been a good bit impervious to meaningfully rising energy costs. Although it may sound like a melodramatic comment, any change in the technical or fundamental prospects of the transport sector would be quite meaningful in terms of suggesting potential forward outcomes for both the broad domestic equity markets and the real economy. At this point, the transports demand ongoing monitoring and analysis at what may be a relatively critical juncture for both the financial markets and economy.

Market Observations
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Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

Contrary Investor is our vehicle for providing what we believe is institutional quality financial market research, analysis and commentary that is characterized by honesty, integrity and credibility. We live the business and hope to bring what we learn from our daily experiences to our work at Contrary Investor. Having checked our egos at the door many moons ago, we hope to allow our work to stand on its own and speak for itself, without the personal promotion of any one individual getting in the way. No investment guru's here. Just lifelong students of and participants in an ever-changing financial marketplace.

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