Our bearish investment stance on the Dow Jones transportation index has been based on the lack of demand for distillates which includes diesel fuel, the primary input for the transportation sector. The inference has been falling diesel demand foreshadows falling transportation demand. This is the result of bloated inventories and lower sales.

Looking further into the data, the monthly sales of No. 2 Distillate are well below trend and have declined significantly over the last few months. There was a brief increase in sales in January 2009 which corresponded with the inventory restocking cycle.

In January and February there was an increase in new orders, which led to stabilization in shipments. However since then, shipments have continued to decline while new orders have increased. As well, the inventory to sales ratio has barely budged over the last two quarters.

The three year average inventory to sales ratio is 1.17, currently the ratio is 1.29. While it has fallen slightly, it is still at historically elevated levels. This implies that inventories still need to be reduced before a new restocking cycle can take place.

Even though new orders have increased, manufacturers will simply use current inventory to fulfill those orders. This explains why shipments are falling despite an increase in new orders. Shipments include not only shipments out of a factory but also those shipments of materials coming in. Therefore we see the amount of shipments remaining subdued until the inventory to sales ratio returns to historical norms. We could even be convinced that the inventory to sales ratio needs to correct below historical norms before any sustained inventory restocking occurs.

Disclosure: I am short IYT