The mood on Wall Street has soured, and for good reason. Investor sentiment is being tested hard. The coronavirus from China is spreading like wildfire around the globe, creating panic among world leaders. Consequently, countries are closing borders and businesses are shutting down.
Microsoft (NASDAQ:MSFT) updated investors about the outbreak’s impact on PC sales yesterday. The airline stocks in particular were hit very hard. Delta Air Lines (NYSE:DAL), for example, is down 20% from recent highs. Most of that drop came in the last few days. It continues to cancel flights to and from impacted areas. It’s not suffering alone, as Southwest Airlines (NYSE:LUV) is also 15% below its January levels.
Investors are right to be nervous, but sometimes they overreact. Today we will examine the opportunities in these two stocks. Perhaps they have been punished too harshly and maybe there are levels where they will find footing. In addition, we will also look at the Transportation sector via the iShares Transportation Average ETF (BATS:IYT) as an alternative to betting on single stocks.
Before we delve into some details it is important to note that the goal today is not to call a bottom. My point here is to assess the upside potential and quantify the downside risk. Catching falling knives is a dangerous practice, especially when the tickers in question are in the direct line of the virus.
Travel and leisure stocks will probably be last to recover, and they started suffering first. Supply chains may have some leeway, but travel will remain challenged until the solution comes. Patience is key and caution is warranted.
Airline Stocks: Delta Air Lines (DAL)
It’s no secret that DAL is a star among airline stocks. But in a year where shares are down 8% while the S&P 500 is up almost 10%, recognizing its star status doesn’t alone justify the bull thesis.
It’s the best of a sector, but it’s in a sector that can’t sustain any momentum on Wall Street. Even though they can’t seem to find a bottom, there are signs the end of their suffering could be near. There are two reasons for that — one fundamental and one technical.
First, Delta Air Lines stock has a little fat left on it. It sells at a price-earnings ratio of 7.9 and a price-sales ratio of 0.8. Investors are not giving its future growth plans very much credit. This is understandable, especially as the future of the business will suffer at the hands of the virus. This timing is unfortunate, as Delta was already dealing with Boeing’s (NYSE:BA) 737 Max mess.
Secondly, DAL’s chart suggests that this last dip brought the stock into a long-term support zone. In December 2014, DAL stock broke out from $43 to new high. It has since used $43 as a pivot, and since 2016, has used $45 as a solid support level. This dip brings the $45 support zone back into view. Bulls assume here that the support will hold, and that alone provides some courage. So, if you are still long, it is not time to panic and sell. There is also potentially enough support here to warrant initiating a new position.
However, it is important to temper enthusiasm, as we do not yet have an all-clear signal.
Now that we see why an investor might want to catch the falling knife, the next question is how. Whatever your preferred method, make sure to start small. That way, if the price continues to fall, you will have more opportunity to manage your position. Going in all at once is reckless, especially under such conditions. The options market offers dozens of alternative ways to buy upside with defined risk. It even offers ways to secure protection for free.
Southwest Airlines (LUV)
Southwest Airlines has a whole fleet of the grounded 737 planes, so its back was already against the wall. Yet, it wasn’t the worst performing of the airline stocks, so it has some fans. Fundamentally, LUV stock is frothier than DAL, so its chart isn’t as pretty. But it, too, is falling into support. It could still get cheaper as its P/E is 10.6 and it sells at 1.4 times sales. There could be more fat to trim if the uncertainty from the virus lingers.
Just like DAL, LUV stock broke out after the 2016 election and has since used those levels as support. This pullback brings that neckline into play. Bulls should have some solace knowing that relief is near. Again, since we aren’t trying to find the absolute bottom, investors will star nibbling if they see a potential buying zone.
This is a proven line — it has been tested three times already from last August, May and March. Only the Christmas stock market crash of 2018 went lower, to $44 per share. So if someone has stayed long this whole period of correction, selling here seems late. Of course, people have different risk tolerances so individuals act based on specific portfolio situations.
iShares Transportation Average ETF (IYT)
The alternative to betting on individual airline stocks would be to bet on a sector exchange-traded fund. The IYT tracks airlines well and is in a similar pickle here. It too has been lagging the benchmarks but also is falling into support.
The advantage of betting on an ETF is that you can avoid single-stock surprise headlines. Investors sometimes cannot do a lot of homework on each company, so betting on the sector eliminates the need to study each line item of the DAL or LUV financials. The only requirement is to have a macroeconomic thesis on the transportation sector. Airlines are not the dominant agents in the ETF, but it is still a valid proxy investment.
To that point, IYT is down 10% over the last 12 months. As the transports fund fall into the $170-range, it should find buyers. The assumption is always that proven support should hold especially when it dates back to 2016. Rarely do sellers slice through such marked pivot zones like butter. The usual behavior is a bounce and that’s where the battle heats up. The bears will try again to break through it on the second try. If they are unsuccessful, IYT may then get a double-bottom to serve as a base for the rebound.
Regardless of how solid a floor seems on a chart, investors need to be humble in their assumptions. When there is a lot of uncertainty, exercising caution is very important. If the floor breaks then a new wave of selling begins. The safest thing to do is wait for confirmation of a trough before engaging to the upside even at the expense of missing a few bucks. As for the upside triggers, any clarification on the Covid-19 disease or on the release of the 737 Max should bring bids into airline and transport stocks.
Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities. Join his live chat room for free here.
