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ANALYSIS-Transports' slump could be harbinger of market trouble

Chuck Mikolajczak
Monday, 27 Jan 2014 | 4:58 PM ET

NEW YORK, Jan 27 (Reuters) - As concerns over emerging markets sent the Dow to its biggest drop in more than seven months on Friday, one emerging technical signal indicates the sledding could be a bit tougher for U.S. equities in the next few months.

On the day the Dow industrials suffered its worst one-day loss since June, the Dow Jones Transportation average slumped 4.1 percent for the session, its biggest drop since September 2011.

Transportation stocks are closely watched because of their role in facilitating economic activity, and one tenet of "Dow theory," where the transportation and industrials indexes are looked at in tandem, is that when both start to fall, more weakness could be in the offing.

The sector was weighed down Friday by Kansas City Southern , down 15 percent after the railroad's quarterly earnings missed Wall Street expectations, but other components also slumped, making the move lower more convincing.

Besides railroads, Dow Transports components include Delta Air Lines and United Continental Holdings Inc, as well as FedEx Corp and United Parcel Service Inc .

Friday's drop in the transportation average came right after a record high on the index on Thursday, marking only the eighth time since 1900 the index lost more than 3 percent a day after a hitting a 52-week high, according to Sentiment Trader.

Of those eight events, the transports only managed to show a meaningful rebound once after three months, and the industrials were positive only 25 percent of the time three months later.

"It could indicate something going on here and we are getting the failure in the Dow theory indicator," said Paul Mendelsohn, chief investment strategist at Windham Financial Services in Charlotte, Vermont.

"Could this be the beginning of a bigger correction? Yes, it could be. Do we know whether it has really started yet? No."

The weakness was extended on Monday, as transports fell 0.8 percent, while the Dow industrials were down 0.3 percent.

But like most technical signals, they are open to interpretation and more easily seen after the fact. Jeffrey Saut, chief investment strategist at Raymond James Financial in St. Petersburg, Florida, feels stocks were due for a pullback anyway and the primary direction for the market remains up.

"It means nothing," said Saut.

"All you have was an upside non-confirmation, where you have the transports in recent history make new all time highs, unconfirmed by the Dow industrials. That is not, repeat, not, a Dow theory sell signal."

The small sample size of prior events ultimately leaves investors with a decision about how much weight to give the potential sell signal, one most likely to be swayed by the belief in the global economic improvement.

"If you are standing on the negative side of the ledger, this would be something you would throw up there in your top five bullet points," said Sandy Lincoln, chief market strategist at BMO Asset Management U.S. in Chicago.

"When you look at how, not only transports but the other economically sensitive sectors were hit, it was probably logical they would be hit harder, but at the same time we would favor the economically sensitive sectors on the belief the global growth story is still intact."

(Reporting by Chuck Mikolajczak; Editing by Nick Zieminski)