As the month of July began, the stock market was in the midst of a rather significant rally and the Dow Jones Transportation Average broke out to all-time highs.
But within a few days, the good times turned to bad as this economically-sensitive sector crumbled.
On Monday, the Dow Jones Industrial Average lost 94 points, though the index was trading even lower earlier in the day.
The bears have apparently resumed control of the stock market and that keeps the market on track to challenge its previous 2011 lows one more time.
When the transports reached their new high recently, followers of the century-old Dow Theory suddenly got excited. The theory states that a major new high in both the Dow Industrials and the Dow Transports means the market is in sync and ready to move even higher.
Of course, the composition of the industrials index has changed drastically and we can argue that truckers and railroads have less to do with transporting products in a service and information-based economy than in the past. But even with such changes, Dow Theory has still been able to keep investors on the proper side of the market for many years.
So when the transports broke out earlier this month, Dow Theory followers were eagerly awaiting the same in the industrials. After all, the stock market was hot, interest rates were low and many commodities, which are input costs for many large-cap U.S. companies, had backed down from earlier highs.
However, it was not to be as the sector's mood changed abruptly. The iShares Dow Jones Transportation Average Index Fund (ticker: IYT) dropped sharply to form a second "gap" on the charts in as many days (see Chart 1).
Chart 1
A gap is simply a price zone where no trading takes place because the market is moving too quickly. Supply and demand become so far out of balance that prices must jump, rather than smoothly trend, to the next level.
The transports fund gapped up with heavy volume on July 7 as it moved through its April high. A technical breakout combined with a gap is normally a very bullish sign, if it holds its ground for a day or two without dropping back. Unfortunately, it did fall back. And making it worse was that the decline on July 8 was also a gap.
A gap up followed immediately by a gap down is called a "gap reversal" and as its name implies, the trend turns from up to down. The transportation sector has been in decline ever since.
Although not as dramatic as gap reversals, similar breakout failures are visible in railroad stocks such as Union Pacific (NYSE: UNP - News) and truckers such as Con-Way (NYSE: CNW - News). Both of these groups were in strong rising trends so technical problems here bode poorly for all transports.
Airline stocks are among the weakest in the transportation sector. Although thinly-traded, the Guggenheim Airline ETF (FAA) illustrates how the airlines group has fallen over the past eight months (see Chart 2).
Chart 2
It also shows a steep breakdown over the past week despite the general malaise in crude oil prices over the same span. Typically, airlines and oil move in opposite directions as fuel makes up a huge percentage of airline costs. That both are weak tells us there are other reasons why investors should avoid these stocks including a solid declining trend.
Shipping stocks are in even worse shape as the Guggenheim Shipping ETF (SEA) probes fresh 52-week lows (see Chart 3). While the ETF is also thinly-traded, the price trend is very clear. Investors see no reason to buy, even at what appears to be very low levels.
Chart 3
Aside from the potential for a Dow Theory buy signal snuffed out, the transportation sector is now in short-term decline. The Dow Jones Transportation Average itself could easily fall from current levels to reach its March low at roughly 4920.
At that point, we'll have to see how it reacts. If it cannot hold on there, forget a Dow Theory buy signal. A Dow Theory sell signal will then be on the table.
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