Chips And Trains

From the desk of Steve Strazza @Sstrazza

Something we discuss a lot, especially internally, is what we refer to as "New Dow Theory."

It's merely the idea that instead of looking at Dow Transports $DJT as the confirming average for Dow Industrials (or the broader market), we should be looking at the Semiconductors index $SOX.

The reasoning behind this is simple, and we won't get too far into it. The bottom line is that as the US has shifted from a Manufacturing to Services Economy, the methods used to transport modern-day goods and services are very different than they were almost a century ago when Dow Theory was first introduced.

If you feel like going down the rabbit-hole on this like I did, here's an excellent academic paper on the "Electronic Transport Properties Of Semiconductor Nanostructures."

As with anything in Technical Analysis, we need to remain flexible and adjust to the new data in front of us. And in recent years at least, one can make a strong argument that the price action from Semiconductors has given us much better information than Transports have.

We don't know what the right answer is, but we know Transports remain a key cyclical area of the economy, so we simply use both.

In this post, we'll look at how the two Indexes have performed recently and what signals they're sending for the broader market.

We'll then outline trade ideas in a chipmaker and railroad stock that are currently offering a favorable risk/reward.

Transports have been on a tear lately. We like this group a lot right now. You can read more about it here.

On the other hand, Semiconductors had been one of the top performers off the March lows, but have been correcting and showing relative weakness since the beginning of the month.

The recent performance from these groups is in direct opposition to their structural trends, as Semis have been in a strong uptrend for the past several years while Transports have been stuck in a sideways range, still trapped beneath their 2018 record highs.

Here's a short-term look at the charts, dating back to the beginning of the year.

Semis just made their first lower low since the March bottom. We'll be watching closely to see if they can reclaim their highs from earlier in the month.

Meanwhile, Transports are pressing on fresh highs as I write this. A bit of a change in character in this relationship, but consistent with the rotation we're seeing lately.

Ideally, we'd want to see both making new short-term highs to support new highs in the Dow Industrial Average, which is still about 5% below its record highs.

The bottom line is if both of these critically important groups continue to trend higher, it's likely happening in an environment where stocks, in general, are still in an uptrend, and the S&P 500 is back above our key 339 level. Here's a look.

Buyers and sellers are battling it out there now. We should see some resolution soon, and Transports and Semis are likely to act as a leading and confirming indicator for whichever direction we head from here.

To support higher prices for the broader market, here's what we're looking for from these two indexes:

• Transports finally make new record highs. They are just about 1-2% away, so it could happen any day now.
• Semis break back above short-term resistance and reclaim their recent highs. They already look to be on their way as I write this.

In terms of how we want to approach these areas from a stock-picker's perspective, as usual, there are winners and losers in each group.

We want to buy the new leaders within Transports, the ones that are breaking out to fresh highs.

But we also want to buy the current leaders within Semis as we believe the group will eventually resume higher, in the direction of its primary trend. When it does, we want to own the names that are showing relative strength and defending key support levels during the recent pullback.

Both of the stocks we're about to discuss are in primary uptrends and offer a clearly defined level to trade against, as well as a favorable risk/reward profile. Here they are.