The transports sector is absolutely key heading into 2013

Start by looking at the Dow Transportation Index if you want to know where stocks may be headed in 2013, says Bill DeShurko, investment manager on the Covestor platform.

“Where the transports go, U.S. stocks are likely to follow,” says DeShurko of 401 Advisor, who manages the Dividend and Income Plus investment model. “They are a measure of the U.S. economic lifeblood. Keep in mind, the U.S. is still the big dog globally. So I suspect that transports will be a leading market indicator.”

As Josh Brown points out, analysts and investment managers have come to recognize that the economically sensitive Dow Transportation Index Fund (IYT) won’t lead the market this year. In the third quarter of 2012, industrial stocks (indicated by the red line above) began making a series of lower highs while the Dow Industrials (in black) began a climb to a nearly five-year high. That happened despite poor economic data from China and Europe.

Yet the weak transports should not have been ignored, DeShurko says. The group was flashing a warning that the Dow Industrials were about to take a 1,000 point tumble in October and November, he says.

A mix of exogenous fundamental factors may have pushed the industrials higher while economically sensitive transports were mainly moving sideways in the third quarter. According to DeShurko, those included:

— Market euphoria over ECB President Mario Draghi’s statement that the European Central Bank was prepared to do “whatever it takes” to preserve the euro currency.

— Expectations that the market would see a Q3 rally in line with past U.S. election cycles

— Expectations in Q3 that the fiscal cliff  would be solved following the presidential election and before the end of the year, to avoid automatic spending cuts and tax increases.

— Anticipation that the release of Apple’s fifth-generation iPhone could help provide a third-quarter lift for U.S. GDP.

Going forward, though, DeShurko believes that economic expectations will be the strongest influence on market direction. And the good news, he says, is that the economy may indeed continue to strengthen – but not with its own propeller. “I think that globally the picture is going to improve, with the data from China and Europe becoming a little more solid. Even if we hit a soft patch in the U.S., I think that the rest of the world will pick up, and that could help keep us afloat for the year.”

“I’m watching the MSCI All Country Asia ex Japan Index Fund (AAXJ) for a potential breakout to year highs,” DeShurko says. “That could be a signal that investors are going to give a much harder look at economies with faster growth than the U.S. in 2013.”