The Dow Jones Transportation Average is finally starting to show some life. While it's still down a lot, there are several stocks worth buying.
The index has fallen about 8% since hitting a multi-year high in late July 2023, while the S&P 500 has risen 20% over the same period.
The divergence is driven by several factors. Big tech stocks have surged, driving the S&P 500 higher, as artificial intelligence becomes a bigger part of the economy and corporate spending. Earnings growth for industrial goods makers remains relatively high as customers invest in new equipment and bring more manufacturing back to the U.S., among other trends.
Meanwhile, earnings expectations for companies that transport goods have taken a hit as growth in overall demand for goods has slowed to the low single digits and it’s unclear whether the Federal Reserve will cut interest rates quickly enough to keep growth going.
Selling fewer products or weaker sales growth means less demand for goods shipped by trucks and railroads. In part, analysts have cut sales estimates for United Parcel Service Inc UPS.N and freight carriers Union Pacific Corp UNP.N, JB Hunt Transportation Services Inc JBHT.O and Old Dominion Freight Line Inc ODFL.O by several percentage points, totaling just over $130 billion.
The decline in earnings expectations has been more severe -- some companies' earnings estimates have fallen by double-digit percentages -- because these companies have many costs that cannot be cut immediately if demand weakens. This has affected profit margin expectations.
The underperformance of such stocks is so stark now that they look cheap enough to buy. The market value of the transportation index relative to the S&P 500 is near its lowest level since the pandemic devastated the economy in 2020, according to Evercore.
This sets up a potential period of outperformance for transportation stocks over the next few years. In the past, when the index was this low relative to the market, buyers have consistently stepped in to support the index, especially when they see that these companies have enough economic strength to generate significant earnings.
This seems to describe the current situation. The job market and economy are still growing. The Fed may cut interest rates soon, but even if it doesn't, it is unlikely to raise them further, removing a major pressure point on commodity demand.
“The U.S. economic slowdown has already begun, but the strength of the labor market does not portend an impending recession,” wrote Evercore strategist Julian Emanuel. He called transportation stocks “a market sector that could find ‘value buyers’ as the third quarter begins and the economy holds up well.”
Those buyers have started to trickle in. The transport index has risen 4% since hitting a low in mid-June, outperforming the S&P 500’s gain of just over 1%. Since it remains historically low relative to the S&P 500, some upcoming events could trigger more gains.
It all starts with economic news. June employment data will be released on Friday, and the stock market wants to see that the U.S. is adding jobs, but not so fast that the Fed removes the possibility of a rate cut. A strong but not excessive result will drive these stocks higher. So will the Fed's desire to cut rates soon, as indicated in its monetary policy statement at the end of July.
An earnings beat would also work. Union Pacific, which reports on July 25, is particularly noteworthy.
The market wants to see the company on track to meet analysts' expectations for 5% sales growth to $24.8 billion in 2024. They expect growth to continue in the coming years.
Management noted in its April earnings presentation that pricing has risen despite modest volume growth in the most recent year, as railroads' extensive routes and decades of consolidation in the industry have enabled them to charge customers more over time.
That growth should help margins and profits rise in the coming years. While wages and other expenses will increase, total costs, especially equipment depreciation, won't rise as fast as revenue. The company is expected to use its profits to buy back more stock, so the consensus on Wall Street is that earnings should grow by low-double-digit percentages in the coming years, according to FactSet.
Any information confirming that these trends remain in place should push the stock higher.
The article is forwarded from: Jinshi Data