MARKET WATCH: What’s Happening? The Transports have been on a roll in 2016, with their growth outpacing both the Dow Industrials and the S&P 500. Some Dow theorists are taking this strong performance (particularly since Brexit) as a “confirmation” that equities overall are about to boom.
Our Take: Investors beware: Transportation’s 2016 comeback has been largely powered by two sectors—railroads and trucking—that are priced much higher than their recent performance warrants. With industrial production shrinking, freight volumes dwindling, and another recession looming, the Transports Index is a near-term short. In other words, the leading indicators of the “Transport” leading indicator are themselves flashing red.
Traders bullish on the Dow finally got what they were waiting for in October when the Transports Index officially “broke out” in absolute terms, rising above its previous 2016 high set back in April.
Back when the year began, the Transports Index was coming off a rough 2015. The index dropped more than 1,600 points from peak (last November) to trough (mid-January).
Then, the fog cleared and the rally began. Even taking into account a Brexit-induced plunge in June, the Transports have grown at a faster clip than both the Industrials and the S&P 500 this year. Since Brexit, the numbers look even better, with the Transports shooting up 12%—roughly double the growth rate of the Industrials and the S&P 500 over that same period.
Many forecasters are taking the index’s recent strong performance as a sign of good things to come for the U.S. economy. Market analyst Greg Guenthner writes that the Transports Index is about to propel the stock market higher to close out the year. Similarly, Mark Newton (of Newton Advisors) recently named the Transports Index one of his top five bullish market indicators—and said that he could see the index jump roughly 500 points to 8,500 or higher.
THE TRANSPORTS AND “DOW THEORY”
So why does this one index matter? Isn’t it just the lesser-known cousin of the “real” Dow, the Industrials Index?
OK, the Transports Index may be neglected. But give it its due. It is in fact America’s oldest active stock index, tracing all the way back to 1884. Its current lineup includes 20 transportation companies judged to be standouts within their respective subsectors—including six airlines, four railroads, four trucking companies, three delivery companies, two marine transportation firms, and one car rental company. The index’s heaviest-weighted components are FedEx (FDX), United Parcel Service (UPS), Union Pacific (UNP), Norfolk Southern (NSC), and Kansas City Southern (KSU).
As for why the index matters, the direction of the Transports Index plays a major role in Dow Theory. Together, the Industrials and the Transports track the production and shipment of U.S. goods, making them a barometer of aggregate demand in the economy. Dow Theory holds that when both indices are “confirming” each other (moving together in the same direction), it’s a solid indication that current stock market trends will persist. On the other hand, when a “non-confirmation” occurs (one index rises while the other falls), it’s a sign that the overall market is about to change direction.
What’s more, the Transports have an excellent track record as a leading indicator, both of the economy (entering and exiting recessions) and of the broader stock market. Prior to the last three U.S. recessions, the Transports Index started declining months before the S&P 500 did. The Transports Index does this job even better than the Industrials Index.
WHY TRANSPORTATION IS PRIMED FOR A SLOWDOWN
Despite the index’s hot performance in 2016, its near-term outlook is bearish. Why? The recent outperformance of the Transports Index has been powered by two sectors—rail and trucking—both of which are struggling by almost every economic measure.
So yes, it may be true that Transport stocks (which are up) are a leading indicator of the entire economy. But most individual measures of transportation (which are down) are a leading indicator of the Transports Index. For instance, going back to 2000, intermodal rail volume has never declined without the Transports taking a hit soon after.
Railroads: not chugging along smoothly. The Transports Index’s strongest performers in 2016 have been railroads like Kansas City Southern and Union Pacific, whose prices have grown roughly three times faster than the overall index.
But the sector’s underlying metrics tell a much different story than its share prices. According to the Association of American Railroads, total U.S. freight traffic over the first 40 weeks of the year was down 7% compared to the same period in 2015. Low commodity prices are still hammering railroads, with coal volume down 25% year over year.
But that’s not all: In Q3 2016, intermodal cargo fell for the second straight quarter—something that has not happened since 2009. On the quarter, rail container volume also fell by 5.3%. Meanwhile, the Cass Freight Index shows that in August, YOY freight activity declined for the 18th consecutive month.
These troubles are reflected in rail’s EBITDA—which have gone into negative territory for the first time since 2009-2010.
So why the dissonance between soaring valuations and plunging business metrics? Many investors are betting that a commodities bounceback, whenever it happens, will be a cure-all for the sector’s struggles. To that end, yes, coal and petroleum are weighing down railroads—but they’re hardly the only products being shipped less frequently in 2016. Shipments of forest products have slipped 7.8% YOY. Metallic ores and metals (-5.7%), nonmetallic minerals (-3.6%), and farm products (-3.1%) are all down as well.
Other analysts, such as Lee Klaskow, believe that slimmed-down railroads are now primed for success: “With less traffic, [railroads] are able to run their networks more efficiently, so you could see margins improve despite the decline in volumes.” That kind of logic only makes sense for some asset-light service business. Not rail, whose lofty fixed- to variable-cost ratio (up to two-thirds of railroad costs are fixed) is the very definition of asset-heavy. This sector absolutely requires high volume to turn a profit.
Trucking: Short the long-haul game. To be sure, trucking has some bright spots if you look hard enough. Trucking volume grew by roughly 3% in 2015. And lower fuel prices cut down on the cost advantage that rail normally holds over long-haul trucks.
But that’s about where the good news ends. Volume has been shrinking YOY for much of 2016. Not only are firms like J.B. Hunt Transportation Services (JBHT), C.H. Robinson Worldwide (CHRW), and Landstar System (LSTR) shipping fewer loads, but they’re earning less per truckload. The Cass Truckload Linehaul index shows that trucking rates have declined YOY for seven consecutive months.
Quite simply, demand is unseasonably weak—as indicated by falling capacity utilization of workers and trucks, which has slid from close to 100% to just 85%, according to one industry expert. Further, the American Trucking Association reports that driver turnover fell 6 percentage points in Q2 2016 to the lowest figure in five years.
A more ominous sign of the sector’s weakness is the months-long decline in YOY heavy truck sales. Going back half a century, this precarious situation has occurred before each recession—and nearly without fail, only before a recession.
Marine transportation and airlines: uniformly negative. While railroads and trucking companies may be performing worse than advertised, marine transportation firms and airlines are performing ugly by just about any standard.
Matson (MATX) and Kirby (KEX), the lone marine transportation companies in the Transports, have been the biggest drag on the index in 2016. These firms undoubtedly have been hammered by stagnant global trade: Worldwide container volumes are on pace for zero growth this year, the worst performance since 2009. It’s tough sailing in these waters.
Airlines are also finding growth hard to come by. Unit revenue for Delta (DEL) has declined for seven consecutive quarters, with CEO Ed Bastian recently stating that U.S. airlines are experiencing the “weakest revenue environment in recent memory.”
Some carriers have used drastic tactics to improve their fortunes: United (UAL) poached former American Airlines (AAL) executive Scott Kirby back in August. Though one can’t blame United for wanting to shake things up, the hiring of Kirby is no magic bullet for the company’s troubles.
Delivery: the lone bright spot within the Transports Index. If you know where to look, there are some good bullish calls to be found in transportation.
Case in point: delivery. The rapid growth of e-commerce has propelled the stock prices of delivery companies like FedEx, UPS, and Expeditors International (EXPD) to new heights. (For my in-depth discussion of the sector, see: “Delivering the World to Your Doorstep.”)
Yes, these firms must now compete with the likes of Amazon for last-mile deliveries. But the vast demand for ever-faster shipments, combined with the growing number of retailers turning to the Web, is a net win for this sector. FedEx’s latest full-year earnings statement shows that revenue from the company’s Ground segment jumped 20% YOY in 2015.
BUT REALLY: DO THE TRANSPORTS EVEN MATTER ANYMORE?
Some analysts claim that, in an era when services and experiences are king, the Transports Index—even Dow Theory itself—don’t matter anymore. And yes, I agree to this extent: The industrial thing-making economy is experiencing a secular decline. I have discussed the drivers of this trend elsewhere. (See: “The Immaterial World.”)
But let’s not go overboard: Heavy industry is still a vital engine behind GDP growth. If anything, the sector’s size is underestimated. According to the BEA, private-sector “goods production” (agriculture and industry) today comprises only 24% of GDP value added. But a rising share of the other 76%—“services”—in effect comprises intermediate inputs to industrial companies. Think of services like PR and HR, which were once done exclusively in-house but are increasingly outsourced.
What’s more, goods-producing industrials make up a disproportionate share of formal, large-scale marketplace transactions, such as imports and exports. They tend to require a vast division of labor and represent durable investment over time—unlike many services, which are often hardly distinguishable from informal nonmarket exchange.
Most importantly, let’s not forget that the making and (even more) hauling of goods is highly geared to the overall economic cycle. Today, the U.S. economy is slowing. If it goes into recession sometime in 2017, transportation will suffer far worse than most other sectors.
Why? Because the multiplier effects that disproportionally helped the Transports coming out of the last recession will disproportionally hurt them during the next downturn.
One reason is that capital expenditures decline faster than final demand once the economy sours. Another reason is the inventory dynamic. Rising inventories coming out of a recession inflate the demand for transportation faster than the rise in final sales. But once retailers start to slash their inventories ahead of a downturn—which appears to be happening, if you look at inventory-sales ratios—the opposite happens. As final sales fall, Transport revenues fall even faster.
The message: Investors looking to bet on the Transports Index should wait before they hop aboard.
