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Will Oil's Recent Rally Prove Troublesome for Transports?


Delta Air Lines, US Airways Group, Southwest Airlines, and United Continental Holdings could be poised for bearish backlash.

Since bottoming near $77 per barrel a few weeks back, crude oil has seen a nice bounce, currently trading around $85 per barrel. While the primary trend remains lower, this short-term bounce could be a sign that black gold has put in a significant low, and could trade significantly higher from here.

What's particularly interesting about this move is that it has come amid a period of dollar strength, which typically leads to lower oil prices. Given the global macroeconomic environment, with growth slowing around the world, this move could be attributed to excessive bearishness among market participants, where too many speculators were caught on the wrong side of the trade.

Below is a daily chart of the US Dollar Futures Index. You'll notice that starting after the sharp decline on July 28, both the dollar and oil have rallied in tandem, after being inversely correlated for most of this year. This could be a sign of an environmental shift within this market.

Since this conflicting move in the two assets, equities have flatlined, essentially unaffected by the intermarket divergences. Going forward, however, one could expect continued dollar strength -- and euro weakness -- to be a headwind for the market itself. Ever since the beginning of the European crisis, domestic equities have traded in a very highly-correlated fashion to the euro currency.

Should the current environment persist, one sector that could experience some difficulty is transportation. Although these stocks have been strong so far this year, higher oil (thus, higher input costs for these firms) could weigh heavily on profitability.

Below is a chart of the Dow Jones Transportation Index (TRAN). You'll notice the inverse correlation between these names and crude so far this year. After the TRAN made an annual high earlier this year, it has since drifted sideways to slightly lower, and appears to have some significant overhead resistance. The recent two-day selloff could be the beginning of a bigger move to the downside.

The one segment within transports that looks ripe for the biggest move down is the airline sector. While strong this year, these stocks have been troubled for some time, with names like United Continental (UAL) in a choppy sideways consolidation period for upwards of two years.

Given the overall sentiment among the airline names, it is difficult to conceive any shift in sentiment that could propel these names higher. Of the four major domestic carriers, not a single analyst covering these names has a "sell" rating. Additionally, the vast majority of ratings are that of "strong buy." This creates future downgrade potential, which could weigh heavily on these names.

While the fundamental environment for these stocks may be changing, it is tough to blindly fade strong price action. Monitor this recent divergence closely, and look for weakness in these names as a signal to initiate a new bearish position.

This article by Bryan Sapp was originally published on Schaeffer's Investment Research.

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