September 25, 2012 / 2:17 PM / 5 years ago

Analysis: Dow transports raise warning flag for U.S. economy

NEW YORK (Reuters) - A slew of profit warnings from transportation companies like FedEx Corp (FDX.N) and Norfolk Southern Corp (NSC.N) is raising questions about whether the overall market will end this year on a high note.

Federal Express trucks head out for deliveries from a FedEx station in Los Angeles, California June 18, 2008. REUTERS/Fred Prouser

An enduring part of market lore is the notion that gains in the well-known Dow Jones industrial average .DJI do not hold unless similar moves in the Dow Jones transportation average .DJT “confirm” them. Strategists tend to look askance when they see steady rises in the 30-stock industrial index when the transportation average is not doing well.

The idea behind this part of “Dow theory” is that manufacturers as well as the railroads, shippers and trucking companies that move their goods are barometers of the U.S. economy’s performance.

That makes the recent moves in these averages somewhat ominous. Over the last six months, the Dow industrials have gained 2.9 percent, while the transports have fallen by 5.6 percent.

This is not the first time that industrials have rocketed upward while the transports were suggesting caution. Transportation stocks hit a peak in mid-1999 but later started to slip, while the Dow continued to rally through early 2000 before stumbling.

In recent months, most railroads and truckers have reported lower shipping volumes as consumers and businesses have worried about the weakening global economy and possible changes in U.S. tax regulations. The resulting profit warnings have pressured transport shares.

Until now, stimulus from the U.S. Federal Reserve and European Central Bank are helping to keep transport stocks from steeper losses, said Paul Mendelsohn, chief investment strategist at Windham Financial Services in Charlotte, Vermont.

If the Dow transports, which closed Monday at 4,960.8, fall below a critical level of 4,860 to 4,900, those shares might plunge and pull other stock indices down in sympathy, Mendelsohn said.

“It might not take much to break those technical levels,” which have held for about six months, he warned. “Then hedge fund and money managers are going to pay more attention, and you’ll probably see the impact across the broader markets.”

Another red flag is that analysts have been cutting their third-quarter earnings forecasts at the same time the market is going up.

As of Monday, analysts on average expect the companies in the Standard & Poor’s 500 index .SPX to report a collective 2.1 percent drop in profit, according to Thomson Reuters I/B/E/S. That is in stark contrast with their estimates of a 3.1 percent rise when the quarter began on July 1.

To be sure, not all analysts subscribe to the Dow theory that transportation stocks are a leading indicator of the broader markets, now that manufacturing is a smaller part of the overall economy.

“The Dow theory did a lot better in the 1960s and 1970s, when manufacturing ruled the economy,” said James Paulsen, chief investment strategist at Wells Capital Management in Minneapolis. The Dow transportation average “is not as great a signal in the last couple of decades, when you now have a much more broadly based, diversified economy.”

GLOOMY FORECASTS

U.S. transportation companies are suffering from a host of problems, including China’s slowdown, a slump in demand for coal shipped by railroad, Europe’s fiscal crisis and high fuel costs.

Another factor weighing on transports: Shipping customers are cutting back on spending because of uncertainty about U.S. tax policies.

At issue is the “fiscal cliff” - the year-end deadline for about $500 billion in expiring U.S. tax cuts and automatic spending reductions set for next year unless Congress can reach a compromise over lowering the budget deficit.

The nonpartisan Congressional Budget Office has said a “significant recession” could result from these massive government spending cuts and tax increases.

At the same time, Republican nominee Mitt Romney is trying to defeat President Barack Obama, a Democrat, in the November 6 election.

“For industrials and transports in general, the election and the fiscal cliff are two looming issues that the market is waiting on,” said analyst Logan Purk of Edward Jones in St. Louis.

Transportation and logistics companies are also worried. At least seven of them - FedEx, Norfolk Southern, UTi Worldwide UTIW.O, Swift Transportation Co SWFT.N, Arkansas Best Corp ABFS.O, XPO Logistics Inc (XPO.N) and Werner Enterprises Inc (WERN.O) have scaled back their profit forecasts in recent weeks. United Parcel Service Inc (UPS.N) led the pack when it cut its outlook in July.

Kansas City Southern (KSU.N) bucked the trend. Its volume grew almost 8 percent in the quarter as the company relies less on coal than its larger railroad peers and is heavily invested in faster-growing Mexico.

LOW HOLIDAY HOPES

FedEx and UPS could benefit from a rush to buy holiday gifts, particularly if businesses with low inventory quickly need more goods than they anticipated.

Both companies could see a fourth-quarter bounce if consumer demand heats up for new technology products that are typically shipped by premium air freight.

But FedEx said that would not be enough to offset demand slowed by a weakening global economy. Although Apple Inc’s (AAPL.O) iPhone 5 is a huge hit, some other technology companies have not yet released their new products.

Trucking company Werner Enterprises (WERN.O) said in its profit warning that more than half of its 11 top retail customers had lower inventory than a year ago.

“It’s not necessarily just because they see lower demand,” said Art Hatfield managing director in equity research at Raymond James in Memphis. “It’s because they see concern about fiscal policy and dysfunction out of Washington and what they may mean for demand three or four months down the road.”

Additional reporting by David Gaffen; Editing by Patricia Kranz and Lisa Von Ahn

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