MorningWord 10/7/14: Fearing Fear Itself $DAL $UAL

by Dan October 7, 2014 9:50 am • Commentary

While we have certainly had our share of sensational global events this year – with videotaped murders by terrorists, mass kidnappings of schoolgirls in Africa, mass killings by a dictator in the Middle East, civil war on the border of Europe, downed commercial airliners – there is nothing that scares the bejeezus out of us the way a deadly contagious virus can.

While the Malaysian Air disasters may have made flyers think twice about getting on planes (we will get a better idea if the downing of the plane over Ukraine in July had any meaningful affect on international air carrier business when we get a look at Q3 earnings in the next couple weeks), most people viewed the missing and downed airplanes as isolated events.

The fear of the unknown with the potential spread of Ebola could be different. Experts agree the chances of a global epidemic are tiny. But reality and perception are two different things when it comes to risk events and financial markets.

Financial assets are pricing in minimal risk related to the potential economic disruption that could come from more and more traveler quarantine situations in the West. The most obvious example would be airline stocks.  The situation this past week, where a United flight from Brussels to Newark was met by the CDC because a man traveling from Liberia was throwing up, previews what could be an all out panic, warranted or not.  Ultimately, he was cleared by examiners and let free, as were the 255 passengers that were on board, but what if more travellers show up in a Western hospitals with ebola having recently been in tight quarters with hundreds of other people on a plane?  One proper scare like this would cause serious hesitation of passengers to book flights, even if the fear is overblown. It wouldn’t take a full blown contagion, it could merely take a few scary cases.

I don’t speak of this with any intention to incite fear, I merely highlight the fact that if there were known cases of Ebola finding their ways to the U.S. by international travelers, I sure as heck would not want to be traveling those routes.  I would reconsider international travel all together.  Whether the real risk was minuscule or not, the potential impact from just the headlines and the concern could be enough to cause a 5-10% drop in traffic, significant enough to affect airlines results over the next few quarters.

Think about it this way – even while it appeared that the two Malaysia Airline disasters earlier this year were likely beyond the airline’s control, the airline still took a financial hit that brought the company to the brink.

Yesterday’s price action in the US airlines was fairly interesting, as they all moved steadily lower from the open, closing down significantly by the end of the day (AAL down 3.6%, DAL down 2.25%, & UAL down 2.75%), and they are now doubling up those losses from yesterday.  Prior to the Ebola threat emerging over the last month (including yesterday’s headline of the first case in Spain), investors in airline stocks had already taken a slightly cautious tone, with all three stocks essentially unchanged since March, compared to a steadily rising S&P 500 index:

SPX vs AAL, DAL & UAL 1yr chart from Bloomberg
SPX vs AAL, DAL & UAL 1yr chart from Bloomberg

This under-performance in airlines has occurred even as oil prices have declined more than 15% over the past 3 months. That would normally be a tailwind for the sector, but investors are clearly concerned about the potential for demand to take a hit over the next 6 months.  Valuations look quite cheap for the airlines sector (8-15x P/E multiples), and analysts are broadly bullish on the sector as a result.  However, airlines also have huge operating leverage, so a hiccup in the traffic growth story that is currently extrapolated forward by analysts could cause a big miss in earnings results over the next year, especially since the bar is quite high.

In other words, airlines have a cheap valuation for a reason.  Air travel is one of the first sectors to decline when international demand dries up.  While the Ebola scare could be little more than a case of overblown media attention, the simple risk that perception becomes reality (a la SARS in China 10 years ago) would be enough to cripple airlines stocks in the next few months.  Given that options are hardly pricing in such a risk, we might look at trades to take advantage of that in the coming days.

The risk of Ebola spreading in the U.S. is not high (thousands will die from the flu, probably zero from Ebola) but the risk of fear spreading to the airline stocks is real.  We would very much be inclined to fade the fear trade in airlines stocks if they were to see 10-15% declines back to support in the coming weeks (AAL at or around $30, DAL at or around $30 & UAL at or around $40).