Transports On The Move

4/19/2010


Early earnings reports have provided grounds for optimism, with bellwethers Intel ($23; INTC), J.P. Morgan Chase ($47; JPM), and CSX ($55; CSX) rallying on better-than-expected results for the March quarter.

While Intel and J.P. Morgan are far bigger companies than CSX — and technology and banking are far bigger industries than railroads — results from the transportation sector deserve close attention. In fact, transport stocks are among the key groups to watch this earnings season, for at least four reasons:

Historically, transport stocks have been leading indicators for the economy and broader stock market, and the group has outperformed since the March 2009 low. A correction in the Dow Transports would heighten the risk of a broader market pullback.

Unlike the consumer-led economic recoveries that began in 1991 and 2002, the current rebound is centered in the industrial sector. U.S. railroad and truck volumes rebounded impressively in the March quarter, so disappointing earnings guidance from transport companies could raise questions regarding the sustainability of the economic recovery.

Because transportation stocks are expensive, the group is likely to be highly sensitive to year-ahead profit prospects. As shown in the nearby table, the Dow Transports are expensive relative to 20-year norms based on price/earnings and other valuation ratios. Transport stocks often begin to rally well before earnings begin to recover, so it is not unusual for the stocks to appear expensive at the beginning of an economic recovery. Still, relative to stocks in many other sectors, transport stocks seem less likely to attract buyers based purely on valuation. Unless expectations for robust year-ahead earnings growth remain intact, transport stocks are likely to suffer.

If transport stocks stall despite robust March-quarter results, it could point to a rotation out of early-cycle stocks. Does the Dow Transports’ 21% surge since Feb. 8 reflect improving expectations for the industrial economy? Or have investors piled into cyclical stocks because of their share-price momentum? The reaction to March-quarter results should help answer those questions.

Conclusion

Earnings season has just begun, but recent strength in the Dow Transports is encouraging. Subscribers should maintain a mostly invested posture while watching the averages and looking for opportunities one stock at a time. Our recommended cash position is 5% to 15%, meaning 5% to 15% of equity portfolios should be in a short-term bond fund like Vanguard Short-Term Investment-Grade ($10.72; VFSTX). With the remaining 85% to 95%, subscribers should emphasize attractively valued growers like Aflac ($55; AFL), IBM ($129; IBM), Raytheon ($58; RTN), Ross Stores ($57; ROST), and Varian Medical Systems ($56; VAR).


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