Watch The Transports -- And Buy Some Of Them

10/27/2014


The Dow Theory is sometimes criticized for its century-old reliance on the Dow Jones Transportation Average, a price-weighted average of 20 airline, airfreight, railroad, shipping, and trucking stocks. But history shows that the Dow Transports do a good job of tracking the transportation sector — and that it is tough to make money in the U.S. stock market when expectations for its most cyclical companies are deteriorating.

Charles Dow and William Hamilton developed the Dow Theory from 1900 to 1929, when railroads were the U.S. stock market's most important companies. Today transportation stocks represent less than 3% of the U.S. market's value. Still, the share-price action of transportation stocks answers the same question as it did in 1929: How much are U.S. companies likely to make getting people and things from point A to point B?

That is a question worth pondering, as the market's recent pullback centered on the potential for an overseas slowdown to drag down a resurgent U.S. economy.

Sector snapshot

After slumping 11% from Sept. 18 to Oct. 13 on worries regarding a slowing global economy, the Dow Transports have rebounded nearly 8%, moving to roughly 4% below the Sept. 18 all-time high of 8,676.19. Broader, capitalization-weighted indexes of the transportation sector have charted similar patterns. In fact, the Dow Transports and broader transportation indexes have tracked fairly closely over the past decade.

The Dow Transports have gained more than 12% in 2014, helped by solid profit prospects. On average, the 20 members of the Transports are expected to deliver per-share earnings growth of 17% for their next fiscal year — compared to 7% for the 30 members of the Dow Jones Industrial Average.

If the Transports can rally to new highs during earnings season, it would suggest the group's prospects are largely intact. A failure to reach new highs would bode poorly for transportation-related earnings, as the group is not particularly expensive considering its expected near-term growth rates. With a trailing price/earnings ratio of 20, the average stock in the Transports trades in line with five- and 10-year norms.

Assuming all 20 Transports exactly meet next-year consensus profit estimates — and all 20 trade at their 10-year average P/E — the average would trade at 9,768, up more than 17%. By comparison, those assumptions put the Dow Industrials at 17,929, up less than 9%.

Because the Transports represent a cheaper way to play continued growth in the U.S. economy, we see them as a key indicator to watch this earnings season. A close above 8,676.19 in the Transports would be encouraging, though it would not mean much under the Dow Theory unless confirmed by a close in the Dow Industrials above 17,279.74. For selective investors, we see opportunities in airlines and railroads.

Airlines

Southwest Airlines ($34; LUV) is among the largest and most closely followed transport stocks. Yet the stock slumped more than 10% in the three days ended Oct. 13 amid fears of an Ebola outbreak, followed by a three-day rally of 7% as such fears ebbed.

The manic price action does not mean the stock market is irrational. It means investors are having a hard time handicapping the potential for an Ebola scare.

Apart from Ebola fears, the news regarding the airline group has been mostly positive, with the industry raising ticket prices this month amid a sharp drop in fuel prices. Delta Air Lines ($37; DAL) and others have indicated that Ebola worries have not dented ticket sales, and consensus profit estimates for nearly all the major carriers have moved higher over the past month.

Airlines are among the best-scoring groups in our Quadrix rating system, with five of the six biggest U.S. carriers earning Overall scores of at least 97. Southwest Airlines earns the maximum score of 100, and the stock is being added to our Long-Term Buy List.

Alaska Air Group ($47; ALK), with an Overall score of 97, is our favorite airline pick based on its discount valuation, growth prospects, and track record of consistent profitability. Alaska Air is a Focus List Buy and a Long-Term Buy. Among smaller stocks, JetBlue Airways ($11; JBLU), with an Overall score of 97, is a Best Buy in our sister newsletter, Upside.

Railroads

Can the U.S. economy pull the rest of the globe through a soft patch? Does the boom in North American energy production have legs, even with sharply lower oil prices?

For answers to such questions, few indicators are more relevant than U.S. railroad stocks. The four largest U.S. railroads earn Quadrix Overall scores of at least 79, with strong operating momentum and earnings-estimate trends countering middling Value scores.

So far, third-quarter earnings season has been a mixed bag for the railroads, with a strong showing from CSX ($34; CSX) and slightly disappointing results from Norfolk Southern ($107; NSC). Union Pacific ($107; UNP), which was scheduled to post on Oct. 23, is our favorite in the group based on its Quadrix scores and well-defined growth prospects. Union Pacific is a Focus List Buy and a Long-Term Buy, while Norfolk is a Long-Term Buy.

Conclusion

When the shares of a company with all the right fundamentals stop making new highs, it sometimes means the fundamentals are old news. Transportation stocks look relatively attractive, and we'd be discouraged if the Dow Transports fail to rebound above 8,676.19. For now, our buy lists have 87% to 89% in stocks.


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