Rail Transport CDS Levels and the Dow Theory

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Includes: BNI, UNP
by: Jim Delaney

Charles Dow, co-founder of Dow Jones and Company, wrote a collection of 225 editorials in the Wall Street Journal between 1851-1902 that, after his death, were collected, organized and represented as the “Dow Theory”. It is, in essence, a combination of what is now known as technical analysis combined with what we call sector rotation in modern parlance.

One of the major tenets of Chuck’s conclusions is that “stock market averages must confirm each other.” Back in the day this meant that a new high (or low) in the index of the 30 stocks in the Dow Jones Industrial Average had to be followed by a similar peak or nadir in the index of transport companies. Much to the bears' dismay, that occurred again yesterday but that’s not the point of this piece.

Instead I wanted to delve a little deeper into the “transport” part of the story as the major form of transport when Mr. Dow was deliberating his theory were the rails and they still are an extremely important component of the U.S. economy. That most people’s initial investment in the rail companies went the way of “I have an idea.com” is a story for another day but is still proof that economically sound ideas survive bubbles all the time.

As the latest earnings front passed through Burlington Northern Santé Fe Corp (BNI) and Union Pacific Corp (NYSE:UNP), both reported but like everyone else in this last batch of income avowals, it wasn’t about what just happened but what is to come.

Both BNI and UNP said that the dramatic drop in volumes they had seen over the past year had begun to stabilize but that signs of a recovery in demand for freight were far from full-fledged.

“Things clearly have stabilized when you look at business demand and there are signs of pickup potential. Still, I don’t see it turning around quickly,” said Jim Young, CEO of UNP.

Of the earnings themselves, BNI reported earnings of $1.18/shr vs. $1.00 for the same period last year. UNP saw their bottom line shrink to $469MM from $531MM a year earlier.

On the CDS side of things, given both companies’ exposure to macroeconomic factors, it is no revelation that CDS levels peaked and stock prices hit their lows on March 9th of this year. From there, painting in broad strokes, CDS levels have fallen as their stocks rose.

What is interesting is that in both cases CDS levels hit their lows for the year on July 31st and have since risen even as shares continue to make new highs.

Given the empirical evidence, this situation is not one that usually lasts for long so at some point either the stock will fall or the stock’s rise will be confirmed by falling CDS spreads.

Just like Chuck’s theory, the CDS/equity model looks for confirmation.

Enjoy the weekend.