Trading Range Within a Trading Range

Bottom Line: Despite having only a weak correlation to oil, transportation stocks have seemingly been marked “damaged goods”, as traders are avoiding the group in spite of a continuing rally.

It’s hard to read any financial media lately without hearing about two things…the runup in oil prices, and the strength in transportation stocks. Nearly always, the runup in transports is considered unusual in light of the runup in oil, as we often read quotes like “The Dow Jones Transportation Average was up today in spite of another rally in oil prices”. The problem with that is that there is just not much of a correlation between oil and transports, as the scatter plot below shows.

A scatter plot shows the correlation between two sets of data. In the chart below, we show the 30-day change in crude oil futures from 1983 through the present compared to future 30-day changes in the Dow Jones Transportation Average (DJTA).

There is a correlation between the two of -.15, which means that theoretically, the 30-day change in oil could possibly explain about 7% of the movement in the DJTA over the next 30 days. While a correlation of -.15 isn’t something that should be disregarded, it is certainly not an end-all, be-all explanation for why transportation stocks move how they do.

Let’s look at this another way. If oil has such a dramatic impact on transports, then large moves in oil should lead to large moves in the transports.

Decline / Rise in Oil Over Prior 30 Days	Future Gain/Loss % in DJTA Over Next 30 Days
Largest 5% Declines	5%
Largest 10% Declines	4%
Largest 20% Declines	3%
Largest 30% Declines	3%
Largest 30% Rises	0%
Largest 20% Rises	0%
Largest 10% Rises	0%
Largest 5% Rises	0%

From this table, we can see that the largest 30-day declines in oil lead to an average gain in the DJTA of around 5% over the next 30 days. Even expanding that out to the largest 30% of declines lead to an average gain of 3% in the DJTA. That is about triple the average 30-day return in the Transports during that time.

However, looking at the largest 30-day increases in oil prices didn’t seem to lead to anything dramatic for the Transports. Whether we look at the largest 30% of rises in oil, or even the top 5%, the average future 30-day return in the DJTA remained at 0%. While there were some steep declines in the Transports when oil rallied strongly, there were also some stiff rallies. For example, after oil rallied its most over the prior 30 days, there were 27 times that the Transports fell more than 10% over the next 30 days. However, there were 24 times that the Transports rallied more than 10% over the next 30 days.

Perhaps because of concerns over oil prices, it seems as though traders have been shying away from buying into transportation stocks in spite of the continuing rally. Take a look at the chart below of assets in the Rydex Transportation Fund.

On the chart, Point A and Point B are relatively similar in that traders rushed into the Transportation Fund while chasing a rally in the shares. Soon afterward, the mini-bubbles burst, leaving many of these traders with losses. Looking at the data since the year 2000, any time assets in the fund reached the $100 million mark, the Transports were lower after 20 days 80% of the time (24 out of 30 instances), showing an average return of -2.1%.

The same thing happened this year, when assets just missed the $100 million mark by a couple million dollars. The clear jump in assets, though, certainly appeared excessive, and the Transports proceeded to decline immediately thereafter. Now, at Point C on the chart, we see that the fund is as high as it has been in 2 ½ years, yet assets in the fund have been mired around $20 million for the past three months. There is clearly no “bandwagon-jumping” now, probably because of the fear that oil is about $16/barrel higher now than it was then. This type of apathy should normally be considered a positive development, so while increases in oil prices are something of a concern for transportation stocks in general, when traders already have sour sentiment on the group, losses likely will not be nearly as great as if they were jumping on rising prices once again.

My contention over the past couple of weeks has been that traders have been fighting the rally to a large extent, thus increasing the probability that the rally would extend. While some of the data we follow continue to support that theory, there is definitely more contradictory data now than there has been in the recent past.

One of those is our R.O.B.O. put/call ratio, which dropped to .46 last week despite the losses in the broader market. This is the lowest reading since mid-July and is a marked difference from what we saw as recently as a month ago. The ratio is not yet in what I would call “sell” territory, but it’s getting closer, and is not something that is encouraging from the long side.

Last week we also saw our Rydex Beta Chase Index spike over 10 on Wednesday for the first time since June, telling us that Rydex traders were 10 times more likely to invest in a “risky” fund than a “safe” fund, definitely a sign of excess. With the losses on Thursday and Friday, the Index has settled back into neutral territory, but it is that type of speculation that we don’t want to see.

In addition, our AIM model of investor and advisor sentiment is back below 40%, a low absolute level which normally suggests caution (though that was a lousy way to look at it in 2003). And, of course, no discussion would be complete without mentioning what everyone else does too – the low levels of implied volatility from the VIX and VXN.

So we have a real mix of readings from a lot of our measures, and when we see that, the most likely market action going forward is one of a trading range, where breakouts shouldn’t be trusted and short-term extremes should be faded. I continue to believe that losses in the intermediate-term should be relatively contained, but when we see spikes in optimism like last week, it will make it very difficult to see substantial upside either. For the moment, we feel most comfortable being flat and waiting for the next low-risk, high-odds opportunity from either side of the ledger.

This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.