DOW THEORY STILL IN DOWNTREND -- RAILS ARE TIED TO TREND OF COMMODITIES WHICH IS DOWN -- WE CAN'T REFLATE WITH A RISING DOLLAR

DOW THEORY STILL IN DOWNTREND... At the start of the 20th century, Charles Dow invented the Dow Theory. It was a simple idea. He created two stock indexes -- one for industrial stocks and one for the transports (which were exclusively rails). His reasoning was that both indexes should rise together in a healthy economy. While industrial companies made the goods, the rails transported those goods to market. One couldn't function without the other. Although he was applying that idea to the economy, his Dow Theory became a basic part of traditional technical analysis. When both indexes are rising together, a bull market exists. When they fall together, a bear market is present. Charts 1 and 2 compare the Dow Industrials and Dow Transports over the last three years. Both are in major downtrends which is bad for stocks and the economy. Although the transports turned down first in the second half of 2007, they retested their old highs in the spring of 2008 before finally peaking. The transports fell sharply during the second half of 2008 and are now trading at the lowest level since 2003 (the industrials have already broken that low). Since most attention is given to industrial stocks, I'd like to examine some driving forces behind the transportation plunge.

Chart 1

Chart 2

TRANSPORTS ARE LINKED TO COMMODITIES... The main premise I'm using is that rails and truckers (which make up the bulk of the transportation index) are heaving influenced by the direction of commodity prices. That's especially true of the rails which are the main movers of commodities. The reddish line in Chart 3 is a ratio of the transports divided by the industrials. The black line is the CRB Index of commodities. There appears to be a correlation between the two lines. The transports underperformed the industrials throughout the 1980s and 1990s as commodities fell. It wasn't until commodities began their major bull move starting in 2002 that transports started to outperform industrials (see box). They rose together until mid-2008 when both peaked.

Chart 3

RAILS RIDE COMMODITY TRENDS... Chart 4 compares an index of rail stocks (red line) to the CRB Index for the last two years. The chart shows the rails peaking along with commodities in mid-2008. [Truckers did the same]. The reasoning is simple. During the five-year commodity boom, rails were the primary movers of commodities. When the commodity bubble burst in mid-2008, the rail bubble burst as well. Which raises another interesting possibility. One of the reasons for the commodity collapse was the upturn in the U.S. Dollar. Chart 5 shows an inverse correlation between the two markets. It also shows the rails peaking as the dollar bottomed last summer. So here's my reasoning. For the Dow Theory to improve, the transports (and industrials) have to start rising. For the transports to rise, commodity prices have to start rising as well. That probably won't happen until the dollar starts dropping. That being the case, a rising dollar isn't necessarily a good thing for the US.

Chart 4

Chart 5

WE CAN'T REFLATE WITH A STRONG DOLLAR ... Why would a rising dollar be bearish for U.S. stocks and the economy? As FDR correctly noted when he took office in 1933, deflation is characterized by falling commodity prices. He decided that the way to end deflation was to get commodity prices rising. He did that by devaluing the U.S. currency. The Fed did the same thing in 2002 when deflation was again a concern. It lowered rates aggressively which pushed the dollar sharply lower and commodities sharply higher (Chart 6). Stocks bottomed later that year. Which brings us to the current situation. With foreign currencies plunging, the U.S. Dollar has become the world's strongest currency. It's pretty hard to "reflate" our way out of deflation with a rising dollar. Rising commodities require a weak dollar. With short-term U.S. rates at zero, the Fed can't lower them any further (while foreign central bankers can). The dollar will probably stay strong until foreigners have completed their easing cycle. In this environment, rising commodity prices (outside of gold) would be a good thing. It's going to be hard to do that, however, as long as the U.S. Dollar keeps rising. And it's going to be hard to get the transports moving again until commodities come back into favor.

Chart 6