Transports in the Crosshairs

The transportation sector lies in the crosshairs of the current economic debate. Hopeful bulls are anticipating a surge in industrial activity during the second half of the year while nervous bears expect planes, trains and automobiles to carry lighter loads well into 2010, with slack demand affecting the entire spectrum of goods, services and travel.

The broad sector is actually composed of four smaller groups, each with unique exposure to the economic cycle. Airlines, railroads, packaging and shipping companies traveled a similar path during the historic bear market to multiyear lows, but their performance has diverged sharply in the last five months. Let's see how this diverse behavior has created new trading opportunities.

The Dow Jones Transportation Average Index Fund(IYT Quote) sold off in three waves between June 2008 and March 2009, coming to rest at a multiyear low near 38. It surged higher for the next eight weeks, hit the 200-day moving average and dropped into a broad sideways pattern that's still in place as we head into the dog days of summer.

iShares Dow Jones Transportation Average Index Fund (IYT) Source: eSignal

Price action in the last two months has carved out a rectangle, with resistance at the moving average. Buying interest has been moderate during the two-week uptick, pointing to increased speculation across the sector. While the straight-up rally isn't likely to yield a breakout, it has brought the instrument one step closer to sustained higher prices.

What the fund needs is a consolidation period that holds in the upper half of this pattern, and sets up a launching lad for a thrust above resistance. That process could take another two to four weeks at a minimum. Alternatively I'd be cautious about chasing a breakout in the next week because risk of a quick downturn is too high.

While the fund offers a direct play on the broad sector, better returns might come from careful stockpicking in the group leaders. In this regard, I'd avoid or sell short the airline stocks because it's a troubled industry facing major headwinds that will continue long after we put this recession back in the closet.