Railroads

Highlights Portfolio Strategy Pricing power has improved across a number of industries, with the exception of technology, a necessary development to sustain an overall profit recovery. The S&P railroads index has surged to the point where it will take massive upside earnings surprises to drive additional gains. Profit-taking is appropriate. Telecom services profit drivers have deteriorated significantly of late, and a full shift to underweight is recommended. Recent Changes S&P Railroads Index - Take profits of 22% and downgrade to neutral. S&P Telecom Services Index - Take profits of 6% and downgrade to underweight from overweight. Table 1 Pricing Power Improvement Pricing Power Improvement Feature Chart 1Pricing Power Is Profit Positive... Pricing Power Is Profit Positive... Pricing Power Is Profit Positive... Momentum remains the dominant market force. Fear of missing out is pulling sidelined cash into the market, supported by a decent earnings season to date and rising economic confidence. While consumer inflation expectations remain very low, market-derived inflation expectations have moved up markedly since the U.S. election (Chart 1), a surprising development given the surge in the U.S. dollar. Inflation expectations are back to levels that existed prior to the 2014 kickoff to the U.S. dollar rally. A shift away from deflation worries is supporting a re-pricing of stocks vs. bonds. That trend could continue until the U.S. economy begins to disappoint, potentially causing inflation expectations to retreat. Our pricing power update shows that while deflation remains prevalent, its intensity is fading. We have updated our industry group pricing power (Table 2), which compiles the relevant CPI, PPI, PCE or commodity-data for 60 S&P 500 industry groups. The table also compares those pricing power trends with overall inflation rates to help determine which areas are at a profit advantage or disadvantage. Based on our analysis, the number of groups suffering deflation in selling prices has shrunk to 19 from 23 in our update last September, and 32 last March. In all, 34 out of 60 groups are still unable to raise prices by more than 1%, but that is also an improvement from the 40 out of 60 industries that couldn't keep a 1% price hike pace last September. The bad news is that less than 1/3 have a rising selling price trend, even if the absolute level is negative, down from 50%, and another third has a flat trend. The implication is that upward momentum in pricing power may already be fading. Where is the pricing power improvement? Deep cyclical sectors such as energy and materials account for the lion's share, reflecting higher commodity prices. However, as discussed previously, 6-month growth rates have rolled over (Chart 2), signaling that the unwinding of the negative rate of change shock has run its course. The technology sector is also notable, as several groups are cutting selling prices at a faster clip. Table 2Industry Group Pricing Power Pricing Power Improvement Pricing Power Improvement Defensive sectors such as consumer staples, health care and utilities remain well represented in the positive category, while a reacceleration in consumer discretionary and financials sector selling price increases has boosted interest rate-sensitive sector pricing power (Chart 2). This would suggest that profit advantages continue to reside in these areas, rather than in cyclical sectors. That is confirmed by the uptrend in developed vs. developing market PMIs. This manufacturing gap would presumably widen further if the U.S. ever imposes import taxes. The latter would weaken developing country exports, thereby forcing currency devaluation and hurting capital inflows. Regardless, the PMI divergence reinforces that, in aggregate, cyclical sectors are not as fundamentally well supported as other sectors, and that a highly targeted and selective approach is still the right strategy (the PMI ratio is shown advanced, Chart 3). Even external factors warn against chasing lingering cyclical sector strength. Using the options market, the SKEW index provides a good read on perceived tail risk for the S&P 500. A rise toward 150 indicates significant worries about potential outlier returns. The SKEW has soared in recent weeks, which is often a harbinger of increased equity volatility and defensive vs. cyclical sector strength (Chart 4). Chart 2... But Is Not Broad-Based ... But Is Not Broad-Based ... But Is Not Broad-Based Chart 3Global PMIs Are Signaling Defense First... Global PMIs Are Signaling Defense First... Global PMIs Are Signaling Defense First... Chart 4... As Are Market-Based Indicators ... As Are Market-Based Indicators ... As Are Market-Based Indicators In sum, the broad market has a powerful head of steam and it could be dangerous to stand in its way, but the rally continues to exhibit signs of a late stage blow-off, vulnerable to sudden and sharp corrections. Maintain a healthy dose of non-cyclical exposure to protect against building and potentially sudden downside overall market risks, while being careful in terms of cyclical industry coverage. This week, we are taking advantage of exuberance in the rail space, and reversing our call on the telecom services sector in response to broad-based erosion in profit indicators. Rails Are Now Priced For Perfection For such a mundane and staid industry, railroad stocks have garnered considerable attention of late. Most recently, rumors that railroad maven Hunter Harrison will be installed at CSX to engineer yet another corporate turnaround have spurred a massive buying frenzy. We upgraded the S&P railroads index to overweight on August 1, 2016. Our analysis suggested that analysts and investors had made a full bearish capitulation, slashing long-term growth estimates to deeply negative territory and pushing valuations decisively into the undervalued zone. That pessimism overlooked efforts to cut costs and stabilize profit margins in the face of waning freight growth, setting the stage for a re-rating. While that thesis has worked out, we are concerned that the needle has now swung too far in the other direction, much like what occurred in the air freight industry. The latter had a steep run up only to disappoint newly buoyant expectations. We took air freight profits in late-November, as the soaring U.S. dollar was an anti-reflationary threat to the anticipated recovery in global trade that both investors and the industry had positioned for. Indeed, industry hiring has expanded rapidly (Chart 5). However, hours worked are contracting (Chart 5). Ergo, the hoped for increase global revenue ton miles has not materialized to the extent that was expected (Chart 5). Over-employment is a productivity and profit margin drag, and we were fortunate to take profits before the payback period. We can envision a similar scenario for railroads. There has no doubt been an improvement in freight activity, and there is more in the pipeline. The question is one of degree. Total rail shipment growth has climbed back into positive territory, and our rail shipment diffusion index, which measures the number of freight categories experiencing rising vs. falling growth, is near the 80% level (Chart 6). The key consumer-driven intermodal segment, which accounts for over half of total freight volumes, has finally begun to recover. Rising personal incomes should underpin credit availability and demand, and therefore, spending. The increase in business sales-to-inventories and growth in Los Angeles port traffic also augur well for intermodal shipments (Chart 6). One caveat is that autos represent a large portion of this segment, and pent-up demand has been fully realized at the same time that auto credit quality is beginning to crack. That could keep a lid on the magnitude of the intermodal shipment recovery. Coal volumes have also shown signs of life after a brutal contraction. Coal is a high margin product and another large freight category, and any sustained recovery would provide a meaningful profit boost. Rising natural gas prices typically bode well for coal volumes (Chart 7), via increasing the cost of competing fuels to burn for power generation. However, it is premature to celebrate, because the abnormally warm North American winter may mean that the rebound in electricity production is passed its peak. That would slow the burn rate and keep coal (and natural gas) supplies higher than otherwise would be the case. Chart 5Stay Grounded Stay Grounded Stay Grounded Chart 6Broad-Based Freight Recovery Broad-Based Freight Recovery Broad-Based Freight Recovery Chart 7Coal Is Critical Coal Is Critical Coal Is Critical History shows that pricing power and coal shipment growth are tightly linked. Selling prices have firmed in recent months, but are not at a level that heralds meaningful improvement in return on equity (Chart 8, third panel). True, rising oil prices typically lead to rail companies reinstituting fuel surcharges. But that is profit margin protective, not expansionary, as true pricing power gains come on the back of increased demand and the creation of bottlenecks. It is not clear that such a point has been reached. The Cass Freight Expenditures Index has been flat for several months, signaling that companies do not intend to raise transportation outlays. This series correlates positively with relative forward earnings estimates (Chart 8). That will make it difficult for rail freight to grow faster than GDP (Chart 9), a necessary development to drive earnings outperformance. Meanwhile, productivity gains may be slow to accrue if freight only grows modestly. Weekly train speeds have been stuck in neutral (Chart 8), and the industry may be in the early stages of a capital spending reacceleration. Rail employment growth has jumped in recent months, which is often a leading indicator of investment (Chart 9). If capital spending begins to take a larger share of sales in the coming quarters, then recent investor excitement may ease, leading to a prolonged consolidation phase. After all, valuations are stretched. Over the past two decades, whenever the relative forward P/E has crossed above a 10% premium, relative forward 12-month returns have averaged -4%, and been negative in 4 out of 5 cases. Overheated technical momentum also warns against extrapolating the latest price gains (Chart 10). Chart 8Earnings Will Only Improve Slowly... Earnings Will Only Improve Slowly... Earnings Will Only Improve Slowly... Chart 9... If Capital Spending Re-Accelerated ... If Capital Spending Re-Accelerated ... If Capital Spending Re-Accelerated Chart 10A Profit Recovery Is Discounted A Profit Recovery Is Discounted A Profit Recovery Is Discounted Bottom Line: Take profits of 22% and downgrade the S&P rails index (BLBG: S5RAIL - UNP, CSX, NSCX, KSU) to neutral, as the index appears to be setting up for a 'buy the rumor, sell the news' scenario. Stay neutral on the S&P air freight index (BLBG: S5AIRF - UPS, FDX, CHRW, EXPD). Telecom Services: Can You Hear Me Now? The niche S&P telecom services sector (comprising 3% of the S&P 500) has served our portfolio well, up 6% since inception. However, operating conditions have downshifted and we recommend lightening up a notch and reducing weightings to underweight. There are five factors driving this downgrade: the relative spending profile, sales outlook, margins pressure, interest rates and capital spending trends. First, telecom services personal consumption expenditures (PCE) have sunk anew after a brief attempt to stabilize last year. While consumer spending on telecom services has increasingly become a discretionary item, the improvement in consumer finances and vibrant labor market appear to be generating even more outlays on non-telecom goods and services (top panel, Chart 11). Second, this spending backdrop has undermined the sector sales outlook. Top line growth has retreated to nil, and BCA's telecom services sales-per-share model is signaling that a contraction phase looms (middle panel, Chart 11). Worrisomely, the latest producer price index release revealed that industry pricing power has taken a turn for the worse, which will sustain downward pressure on revenue growth. Third, profit margins are under stress. Selling prices are deflating at a time when the wage bill is still expanding at a mid-single digit rate. The implication is that margins, and thus earnings, are unlikely to improve much in the coming quarters (Chart 12). Chart 11Sales Prospects Have Dimmed Sales Prospects Have Dimmed Sales Prospects Have Dimmed Chart 12Ditto For Profit Ditto For Profit Ditto For Profit Fourth, telecom services is a high yielding sector and the recent sell-off in 10-year Treasurys (UST) is an unwelcome development. When competing investments rise in yield, the allure of telecom carriers diminishes, and vice versa. Chart 13 shows that relative performance momentum and the change in UST yields are inversely correlated, underscoring that as long as the bond market selloff persists relative share price pressures will remain intact. Finally, industry capital expenditures are reaccelerating, which is a short-term negative for profitability. This message is corroborated by the government's construction spending release, which shows a pickup in telecom facilities construction (bottom panel, Chart 13). Taken together with the deteriorating sales backdrop, higher capital spending would be negative for profit margins. While we would normally be reluctant to move an attractively valued sector all the way to underweight (Chart 14), the marked deterioration in these five drivers of relative profitability warrants such an extreme move, regardless of our reticence about the sustainability of the broad market's recent gains. Chart 13Higher Bond Yields Aren't Helping Higher Bond Yields Aren't Helping Higher Bond Yields Aren't Helping Chart 14Technical Breakdown Technical Breakdown Technical Breakdown Our Technical Indicator has crossed decisively into the sell zone, and the share price ratio has failed to break back above its 40-week moving average, providing technical confirmation of a breakdown (Chart 14). Bottom Line: Lock in profits of 6% in the S&P telecom services sector since the Nov 9th, 2015 inception and downgrade exposure all the way to underweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

The S&P railroad index has vaulted higher, along with many other industrial groups, but it may be starting to overshoot fundamental improvement. Technical conditions are becoming overbought. The 52-week rate of change is nearing previous peaks, with the exception of the spike during the GFC in 2008/2009. Relative valuations are also stretching to the point where imminent earnings improvement may be required to sustain outperformance. While rail freight growth has improved, and coal is shifting away from acting as a major drag, productivity growth is not yet showing through. For instance, weekly train speeds have eased. Meanwhile, this capital-intensive industry may be about to boost investment. The chart shows that railroad employment leads our capital spending-to-sales proxy. The latter had plunged as railroads moved aggressively to protect margins during the downturn, and any premature reversal could cut short the earnings recovery. We are overweight this group, but are putting it on downgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5RAIL-UNP, CSX, NSC, KSU. bca.uses_in_2016_12_07_002_c1 bca.uses_in_2016_12_07_002_c1

The transport group is a positive exception to our otherwise downbeat view on the relative performance prospects of the overall industrials sector. We expect consumption to continue outpacing capital spending, because corporate sector free cash flow is waning and balance sheets are suspect. The railroad group in particular has room for upside surprises. Expectations have been reduced considerably, yet leading revenue indicators have perked up. Our rail freight diffusion index has been holding above the key 50 level for several months, heralding increased traffic. Importantly, the heavyweight intermodal segment should soon recover, based on the message from rising consumer income expectations. Importantly, pricing power has climbed out of the deflation zone, a critical milestone for profitability. We reiterate our overweight position. The ticker symbols for the stocks in this index are: BLBG: S5RAIL-UNP, CSX, NSC, KSU. bca.uses_in_2016_10_06_001_c1 bca.uses_in_2016_10_06_001_c1

Transport stocks have discounted a recession, trading below trough bear market relative valuations. That is too cheap given signs of stabilization in global export growth.

Investors looking for a lower risk vehicle to participate in broad equity market strength than from chasing momentum driven areas with dubious fundamentals need look no further than the S&P rail index. Expectations have been crushed and valuations are on the cheap side of neutral. While rail freight is currently in a funk, leading indicators have perked up, particularly for the largest category, intermodal. The latter largely reflects the transportation of consumer goods. Thus, the surge in personal bank loans, strength in trucking tonnage and port traffic all bode well for a recovery in freight in the coming quarters. Against a backdrop of steep cost cutting, any stabilization in top-line performance should have an immediate positive impact on the bottom line. We upgraded to overweight in Monday's Weekly Report. The ticker symbols for the stocks in this index are: BLBG: S5RAIL: CSX, KSU, NSC, UNP. bca.uses_in_2016_08_03_001_c1 bca.uses_in_2016_08_03_001_c1

It is dangerous to equate recent equity strength with economic vitality, as history shows that liquidity-fueled equity advances favor non-cyclicals over deep cyclicals. Take profits in gold, buy rails and sell industrial machinery.

The previous Insight showed that rails are working hard to reduce cost structures. However, rail profits are still tightly linked with overall freight trends. The decline in total railcar shipment growth warns that rail earnings estimates will continue to lag those of the broad market. The two major freight categories are struggling. Coal shipments have plunged, with no imminent relief in sight, as utilities, the primary coal purchasers, are suffering from a contracting electricity production. Meanwhile, intermodal shipments, the largest freight category, have slipped into negative territory. Sagging port traffic, soggy retail sales and high inventory-to-sales ratios suggest that demand for consumer goods will remain lackluster. As a result, deflation is likely to prevail a while longer and we continue to recommend only a market neutral weight, despite the appearance of good value. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, NSC, CSX, KSU. bca.uses_in_2016_05_18_002_c1 bca.uses_in_2016_05_18_002_c1

The relief rally in rail stocks has stalled at key resistance levels, but good value and extreme cost cutting efforts make it tempting to buy into any short-term weakness. Would that be a sound strategy? Top-line growth is lagging far below the rate of overall GDP growth, which is a bearish sign. However, rails have aggressively slashed costs, as both employment and capital spending have plunged. Moreover, the decline in railcar order backlogs suggests that new cars are coming on line. Rail operators lease the bulk of their cars, and tight supply in recent years boosted lease rates. As new cars hit the network, then lease rates should ease. These factors warn against extrapolating bearishness, but are they enough to bolster rail profits? Please see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, NSC, CSX, KSU. bca.uses_in_2016_05_18_001_c1 bca.uses_in_2016_05_18_001_c1

The S&P rail index has bounced off its lows but continues to lack profit support to extend the recovery attempt. Total railcar shipments remain under pressure, which signals ongoing weak utilization rates and low odds of a reversal in selling price deflation. Coal markets are likely to stay under pressure as a consequence of high utility coal inventory levels, as electricity production was adversely impacted by an unseasonably warm North American winter. The latest retail sales report was also soft, and has sustained downward pressure on the retail sales-to-inventory ratio. That can be a decent leading indication for intermodal railcar shipments, the largest freight shipping category. Thus, despite attractive valuations and aggressive cost cutting efforts, we maintain a neutral weighting, preferring another industrials group to benefit from a slightly more reflationary tone in overall markets, please see the next Insight. The ticker symbols for the stocks in this index are: CSX, KSU, NSC, UNP. bca.uses_in_2016_03_16_001_c1 bca.uses_in_2016_03_16_001_c1

We recommended buying into rail weakness in November, on the view that a poor earnings outlook was already discounted and that shipment and pricing power trends would improve as 2016 progressed, allowing cost cutting efforts to shine through. However, this call was too early. Despite attractive valuations and the contrary allure of moving to overweight in the midst of recessionary conditions, the anticipated recovery in freight volumes may be more distant than we had envisioned. Domestic economic disappointment is a rising threat, owing to tightening financial conditions, exacerbated by the stubbornly hawkish Fed. Intermodal rail shipments, which account for nearly half of total freight growth, are not growing. Meanwhile, coal shipments are still a major drag. Warm North American winter weather and a manufacturing recession are keeping a lid on electricity production, which will delay any rundown in utility coal inventories. Consequently, a restocking phase, and recovery in coal shipment volumes, is not imminent. Consequently, we recommend paring back to neutral, recording a 5% loss, and shifting into another industrials group, as discussed in the next Insight. The ticker symbols for the stocks in this index are: UNP, CSX, NSC, KSU. bca.uses_in_2016_02_17_002_c1 bca.uses_in_2016_02_17_002_c1