Airline stocks are generally regarded as the ultimate cyclicals, but the sector has demonstrated some very defensive qualities throughout the spring sell-off. Even as the broader market spent the month of May staggering to a loss of 6%, the NYSE Arca Airline Index (XAL) was virtually unchanged with a return of -0.08%.
Looking slightly further back, airline stocks are actually the top performer among the 99 Dow Jones industry groups in the past three months — soundly beating such traditional defensive stalwarts such as beverages, utilities and telecommunications stocks.
It hasn’t always been this way. In the past, airlines could be counted on to underperform the broader market when stocks started heading south. In 2007-2008, for example, the XAL plunged over 58%, lagging the 36.3% loss of the S&P 500 by over 22 percentage points. In the post-tech bubble crash of 2001, XAL was off 30.8% on a year-to-date basis on the day prior to the 9/11 attacks, versus a loss of 17.3% for the S&P.
What’s different now? It’s true that airlines have reduced capacity and grown more willing to pass on costs to their customers. But the main factor helping the sector in the past month has been the weakness in oil prices, which in turn has led to a sharp drop in the price of jet fuel.
Using the United States Oil Fund (NYSE:USO) as a proxy, oil is off nearly 20% since the beginning of May. The dramatic downturn has prompted leading airline analysts to boost earnings estimates and increase their price targets aggressively. In a report last week, JP Morgan analysts noted: “Lower fuel has a material impact (and) jet fuel prices have collapsed roughly 40 cents per gallon since February, representing an annualized $5.5 billion windfall for the industry. Yet, since the end of earnings (season), consensus has barely budged. Consensus appears wholly inadequate to us.”
For traders, the most interesting aspect of these developments is that airlines are showing signs of becoming a relatively safe haven during periods of elevated risk aversion. Though trite, the term “risk on/risk off” applies when it comes to the relationship between oil prices and the broader equity market. The two have moved virtually in tandem during the past two years, rising together in risk-on periods and falling together when risk is off. From USO’s inception in 2006 through the beginning of the first Europe-related decline in May 2010, the ETF had a correlation of 0.55 with the S&P. In the period since, the correlation has risen to 0.74.*
As a result, stocks that can benefit from weakness in oil prices may now be more likely to outperform during market downturns than they did in the past. In airlines’ case, the biggest winner in this scenario would likely be US Airways (NYSE:LCC) since the company doesn’t hedge its fuel costs. Indeed, the stock is up over 57% since April 1.
The likely loser? Southwest Airlines (NYSE:LUV), which hedges aggressively and therefore has a lower correlation with the price of oil. LUV has outperformed the broader equity market since April 1, but its gain of 6.7% pales in comparison to the move in LCC.
It should be noted that outperformance for airline stocks in down markets is no sure thing. This strategy has worked in the most recent sell-off, and it also would have worked during the market downturn in mid-2010. From May 3 through July 2, 2010, the XAL returned -9.35%, but it outperformed the -14.68% return of the S&P thanks in part to a more than 20% drop in oil prices. In last year’s sell-off (July 22-Oct. 3), however, airlines were hit for a loss of 28.4% — far below the -17.8% return for the S&P.
This helps serve as a reminder that airlines will always have more than their share of volatility. But with healthier industry fundamentals and an improving track record of performance in down markets, it may pay to take a closer look at this sector the next time investors hit the “off” switch on risk.
* Correlation measures how assets move in relation to one another. A correlation of 1.0 indicates a perfect positive correlation, while a correlation of -1.0 indicates a perfect negative correlation.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.