What’s Wrong With this Chart?

25 January 2014

Introduction

Shown in the chart are the DOW’s Transportation Index (^DJT) and DOW’s Commodity Index (^DJC) superimposed over the past 20 years.  There are obvious divergences and convergences between the two index.  Divergences usually happened just before any crisis and the index will converge soon after that.  Recently,  we see divergence with  ^DJT taking off mid 2011 and ^DJC going the other direction.   Lets examine closely what are the causes and  implications

Relationships Between

DJC and DJT

DJC is an index that tracks all the commodity futures that are traded in US.  DJT much Like DJI, the DOW JONES Industrial Index, consisted of about 20 US companies such as FedEx that deal with airline and rail transportation. 

As more produce like iron core, corns etc come on-stream,  more transportation will be needed.  Rightfully speaking,  the better the performance in DJC,  the better will be the performance of DJT and vice versa.  However,  there are rare occasions that over production causes  commodity prices to slump and affects only the commodity price index;  similarly,  a rise in fuel cost will cut transportation companies’ profit.

DJT and DJI

Some argued that DJT was more related to DJI than DJC.  This is because companies in DJI rely on transportation shipments to stock and sell their goods.  When DJI companies anticipate a positive performance, they will increase production of goods that will be needed to be transported between different outlets.  The two indexes inter-twine each other most of the time.

Actually,  DJI,  DJT and DJC are in a value chain except DJC is based on commodity futures indexes whereas DJI and DJT are based on stock prices of the companies.  If the external factors such as QEs are removed,  these 3 indexes should go hand in hand.

Present Development

As can be seen from the chart,   DJT took off mid of 2011 whereas DJC went the other way.  It is obvious that DJT is tracking along with DJI  whose prices have been affected by Bernanke’s QE programs.   

Why?

One reason could be because US are still heavily depended on import of commodities and the production of commodities overseas are more affected by supply and demand rather than the US’s QEs.

Where would the Prices go?

The chart shows that ^DJT and ^DJC wondered around sometimes but they always  converged and move in tandem afterwards.  It can also be seen that whenever there is appreciable divergence between the two indexes,  a recession soon follows;  they will  converge again by the time the recession is over. This happened in around year 2000,  2008 and mid 2011.  Year 2011 was an exception where an intended recession was saved by Bernanke's Operation Twist and QE3.

We are now in year 2014 where one can see the great divergence again between DJT and DJC.  It is therefore likely that these 2 indexes will again converge in the future.   But before the  convergence,  would we not see another recession?