Following the Federal Reserve's announcement of QE3 on Thursday, as shown by the chart below, stocks and commodities surged, while the dollar plunged.
Click to enlarge
Airlines Fail To Participate
Despite the more than 1.5% move higher in the S&P 500, as shown by the chart below, all of the major airline stocks, United Continental (UAL), Delta Air Lines (DAL), US Airways (LCC), Southwest Airlines (LUV), and Spirit Airlines (SAVE) closed Thursday's trading session in negative territory.
Oil Inverse Correlation
The reason why airline stocks failed to participate in the QE3 rally has to do with their inverse relationship with oil prices. As shown by the chart below, when oil goes up airline stocks tend to fall, when oil goes down airline stocks tend to rally. The reason for this is, of course, that jet fuel, a derivative of oil prices, is a a major input cost for airlines.
In the past, I have discussed bullish airline trades on basis of lower oil prices. Because of their inverse relationship with the price of oil, airline stocks have proved capable of moving higher, while the stock market as a whole moved lower.
As previously shown, oil prices, along with most other commodities, notably gold and silver, surged on Thursday following the announcement of QE3. The move higher in oil led to selling in airline stocks. A further move higher in oil will likely lead to more downside in airline shares.
QE3 Won't Work
Many market pundits, notably Jim Rogers, have argued that QE does not work. In short, the argument against QE3 is that it does little more than lead to higher prices. Those who are opposed to QE often state that the effects of QE1 and QE2 on the real economy were minimal, as the economy has still failed to recover. Interestingly, airlines are in a position to feel the adverse effects of QE without feeling the positives. Fuel cost for airlines are almost certain to move higher, while the impact on global economic growth, and hence flight demand is questionable.
Buying Other Stocks
One conventional way to play QE has been through equities. Generally speaking, most stocks tend to benefit from QE for a few reasons. Most importantly, QE lowers the value of the U.S. dollar, which means that stock prices need to increase for valuations to remain the same. Additionally, sectors of the market exposed to commodity price increases, such as oil companies and mining companies, tend to do very well.
However, the long-term sustainability of the QE stock market rally remains questionable. For example, bank stocks such as Bank of America (BAC), Citigroup (C), and JPMorgan (JPM) traded sharply higher on Thursday. However, for these stocks to continue to rally, the economy needs to improve. If the economy, especially the housing market, does not improve because of QE3, then these gains will likely be given up. It should be noted that QE1 and QE2 failed to give a boost to the real economy and thus banking stocks have been among the worst-performing sectors since the start of QE.
Short Airlines Instead
For airlines, if QE3 fails to improve the real economy, not simply increase asset prices, difficult times will likely follow. If the Fed's new program simply succeeds in pushing up asset prices and does little to help the real economy, then airlines will face increased input cost without any increase in demand. Jim Rogers said in a recent interview:
They are a little bit embarrassed because they announced QE1 and QE2, and it did not work. So they may try to disguise it. They may just continue to do it without getting egg on their face again, but they are going to print money, they are all going to print money. It is the wrong thing to do, but that is all they know how to do.
For investors who believe, like Rogers, that the Fed will continue to print money even though it is "the wrong thing to do," shorting airlines is the perfect trade. Increases in commodity prices without increases in real economic growth spell disaster for airline stocks.