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A Cup With Handle In Transports

05/31/07 03:13:14 PM
by David Penn

As crude oil breaks down, the consolidation in the Dow Jones transports hints at a move higher.

Security:   $TRAN, IYT, AMR
Position:   N/A

With all the commotion about gas prices, there has been less attention paid to the behavior of both crude oil and transportation stocks. Given the backdrop of panic as the summer driving season begins in earnest, a speculator might assume that crude oil was in an advancing mode and transportation stocks were in the retreat.

A check of the two charts reveals, however, that crude oil is actually in a corrective rather than advancing mode. As for transportation stocks, the cup with handle–shaped consolidation they have been meandering through since late February looks ready to resolve itself with a breakout to the upside.

FIGURE 1: DOW JONES TRANSPORTATION INDEX, DAILY. The highlighted section in late April and throughout May points out the handle to a relatively tall cup in this cup with handle consolidation pattern. Follow-through to the upside could take the DJTA to as high as 5700 in an initial move.
Graphic provided by: Prophet Financial, Inc.
It could be argued that there are two cup with handle patterns in the daily chart of the transportation average (Figure 1). The larger pattern begins in late February, completing the cup in late April, and adding a handle over the course of May. The smaller pattern sees an up formation from late April to early May, with a smaller handle from mid-May to the end of the month.

In any event, the chart suggests that transportation stocks are about to move significantly higher over the next several weeks. I've seen business cycle maps that posit transportation stocks at the beginning of an economic expansion and other maps that show transportation stocks as getting bids late in the early expansion phase — so much so as almost be a part of the middle expansion during which inflationary pressures begin to mount. Regardless of which location in the business cycle is the most accurate for transportation stocks, the fact remains that if those stocks are set to move higher, then the economy is likely still on solid ground.

FIGURE 2: AMR CORP., DAILY. A positive divergence over the course of the spring and a newly overbought market on the bounce suggest the possibility of higher prices for AMR this summer.
Graphic provided by: Prophet Financial, Inc.
Based on the behavior of commodities like gold and crude oil, I'm inclined to put transportation in the early expansion group and, for the sake of compromise, I'll say "middle of the early" expansion.

The basic business cycle game plan suggests that advancing transportation stocks are a sign of a market that is moving through the "early expansion" part of the cycle. This part of the cycle also tends to augur well for industrial and basic materials stocks as the business cycle moves deeper into expansion.

For those who want to trade the transports directly, the exchange traded fund, IYT, features virtually the same cup with handle pattern that we see in Figure 1 of the transportation average. As for individual components of the transports that might disproportionately benefit from a breakout in the average, one stock that seems worth watching is AMR, also known as American Airlines (Figure 2). As I will detail in a separate article, the airline stocks, as measured by the index $XAL, have been in a bear market for virtually all of 2007 and may be ripe for reversal. However, AMR has begun to rally in the wake of positive divergences in the moving average convergence/divergence (MACD) histogram. There was even a short-term 2B bottom between the lows on May 1 and May 15 that suggested higher prices in the near term.

David Penn

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