Street analysts are saying that, because of higher oil prices, the Dow Jones Transportation Average is showing a real divergence from the rest of the stock market. According to Dow Theory, confirmation from this index is required in order to uphold the primary trend in the stock market. It’s kind of an old-fashioned way of predicting the stock market, but I do believe in it.
Oil prices have been stronger lately because of geopolitical concerns, but a lot of the stocks within the index also performed extremely well up until early February. They’ve been due for a price correction and, after January’s very strong start, this isn’t a surprising development.
Union Pacific Corporation (NYSE/UNP), which is a benchmark stock that I follow weekly, saw its share price correct significantly between August and October last year. This was during a period when oil prices went down. Since the beginning of October last year, UNP’s share price turned around, going from a low of around $80.00 a share to a recent all-time high of $117.40 per share on the stock market. And this was done while oil prices were slowly ticking higher. A lot of other stocks that comprise the Dow Jones Transportation Average also performed similarly, especially among railroad and trucking companies. So, in my estimation, we can’t just attribute weakness in the index to higher oil prices. Many of the component companies have been trending higher since last fall.
I’ve mused before about problems with the country of Iran and how these geopolitical events are contributing to higher oil prices. (See The Market Strategy You’ll Want to Use Later this Year.) The stock market is still more worried about the sovereign debt crisis in the eurozone, but I view the issues with Iran as probably the most important risk to the stock market this year.
Oil prices are reasonable as far as I’m concerned. They were a little undervalued last year below $100.00 a barrel. Given all we know about crude supplies, declining production in major fields, and steady demand, $100.00 oil is a fair reality. If U.S. gross domestic product (GDP) were to accelerate over the coming quarters, oil prices would most certainly spike higher.
Getting back to investment risk in the stock market; it’s still a very uncertain world out there and the potential for new shocks is high. The sovereign debt crisis is a big one and we can’t forget that it hasn’t gone away. It’s only been sugarcoated. We’re also in a slow growth environment and that makes it difficult for mature economies to grow their way out of debt. The U.S. is the perfect example. So, even though the stock market’s had a strong start to the year, I think a conservative stance is still warranted. Investment risk is now more important than expected return.