What It Means for Stocks When Dow Transports Lead the Rally

The following is a reprint of the market commentary from the December 2016 edition of The Option Advisor, published on November 17. For more information, or to subscribe to The Option Advisor -- featuring 10 new option trades each month -- click here.

In the face of a U.S. presidential election result that was received with what appeared to be globally unanimous surprise, equity futures plummeted overnight -- but stocks then roared higher in the days that followed, with sectors expected to benefit most from the new administration leading the charge. And with one of the primary focuses expected to be infrastructure, the good old Dow transports had quite a week. In the Monday-Friday stretch surrounding Election Day (which saw stocks bolting higher at first on a Clinton "relief rally," as the former Secretary of State was cleared of the prospect of email-related charges, and then surging anew following President-elect Donald Trump's victory), the Dow Jones Transportation Average (DJT) gained a robust 6.2%.

The big move higher for DJT drew some Dow Theory enthusiasts out of the woodwork, including analysts at Oppenheimer, who crowed as early as Nov. 7 that "transports are a bullish tell," and the DJT's strength was, in their view, "the 'right' leadership" for the broader market. This postulation, of course, is not new or exclusive to any specific brokerage firm or analyst; the Dow Theory has its basis in technical analysis performed over a century ago, one tenet of which states that strength in the shipping and rail stocks needed to transport goods -- a sign of healthy demand and production -- is more or less a prerequisite to strength in the broader market.

But during that wild election week, it was impossible not to notice that the Dow Jones Industrial Average (DJIA) itself fared quite well, having notched a gain of 5.4% (and achieved a new record high in the process) by Friday's close. And if the Dow's percentage gain was not quite as lofty as the more sector-specific DJT, it's worth remembering that the broader Dow carried the handicap of weakness in Apple (AAPL) -- a member of the big-cap tech space that's not expected to curry any particular favors from the new administration. So can we legitimately expect that last week's strength in DJT was a leading indicator for continued gains in the broader Dow, or was the transport surge simply a coincident confirmation of the existing rally?

Looking back to 1900, our Senior Quantitative Analyst Rocky White compiled data showing instances where the Dow rose 5% or more over a span of five trading days. The returns were then segregated by whether the transports had outperformed or underperformed relative to the Dow over this five-day surge, and ensuing returns for the Dow were measured for each instance.

When the Dow has a good week, but DJT has an even better week, the Dow returns going forward are more impressive than when the transports lag the industrial benchmark. While the "percent positive" is nearly identical over the next one-week and two-week periods -- and, in fact, the "average negative" returns are quite similar, as well -- the "average return" for both of these time frames is considerably higher when DJT outperformed. That's because Dow returns under these circumstances have more volatility to the upside. So while the Dow is only slightly more likely than usual to advance in the weeks immediately following a big, transport-led rally, such advances are likely to be substantial. In this respect, the DJT leadership can be viewed as a confirmation indicator that there's likely to be more left to the rally (at least, in the short term).

And for those now convinced (or perhaps reassured) that the transports are worth watching as an indicator of market breadth and strength, let's take a look at some of the noteworthy technical levels for DJT, which settled at 8,791.23 on Thursday, Nov. 17.

• DJT broke above its 80-week moving average, currently at 7,889.95, in September. This moving average had acted as resistance on multiple occasions since DJT broke below it in July 2015.
• The 8,000 millennium level has been significant since July 2015, and DJT is now trading well above this round number.
• 8,379 is the price point corresponding with a 10% drawdown from DJT's November 2014 all-time high (9,310.22). In other words, DJT is now less than 10% away from its record high for the first time since moving below this level in May 2015 -- and this region previously acted as resistance for daily and monthly closes from June through November 2015.
• Back in August 2015, DJT peaked just shy of 8,536, which marks a quadruple of the index's March 2009 low.