Watch the Skies to See if Stocks Will Soar

Psst. Hey, buddy. Want to know what's the on the radar screen for 2002? Want to know what indicator to watch?

I've got one word for you.

Airlines.

Trying to figure out if the post-Sept. 21 rally will power into 2002 on signs that the economy is recovering from the recession?

Puzzling over the possibility that this rally will peter out like a similar rally did last April, and usher in a renewed bear market for 2002?

Calculating the odds that 2002 will be characterized by strong rallies and almost equally strong pullbacks that leave the market moving sluggishly upward as the economy recovers more weakly than expected?

Then I suggest that you watch the behavior of stocks in the airline sector in January and February. The direction of prices in this sector will give you one of the earliest and most reliable indications of how the market will break in 2002. That's because the stocks have run up so strongly since the Sept. 21 market bottom, and because they're headed into a period of traditional weakness. Whether the group continues its rally or sells off will tell investors a lot about market sentiment.

In my last column, Both Bulls and Bears Have it Wrong, I voted for the third alternative and suggested that contrarian investing strategies that used market volatility to buy out-of-favor sectors low and to sell them after investor sentiment had shifted would be the most profitable way to play 2002.

But since it's always wise to consider the possibility that a strategic judgment is dead wrong, I'll be looking at airline stocks for confirmation of my read on the character of the market in 2002. And I'll be looking at this sector for guidance on how aggressively I need to buy and sell sectors that are rotating in and out of investor favor. (Of course, I won't pass up any opportunities to make a profit by investing in the sector in 2002, either. For some early thoughts on picking airline stocks see my Oct. 12 column, How to Pick the 'Right' Risky Stock.)

Too Cheap to Pass Up

Let me explain why I think the airline sector is such a good market indicator right now, and what signs are likely to be important as we move into the new year.

Almost the entire airline sector has been on a tear since the market bottom of Sept. 21. From that date to Dec. 7 -- the recent peak for many of these stocks -- Alaska Air Group (ALK Quote - Cramer on ALK - Stock Picks)climbed 69%, Continental Airlines(CAL Quote - Cramer on CAL - Stock Picks) took off by 76%, Delta Air Lines(DAL Quote - Cramer on DAL - Stock Picks) soared 37% and Southwest Airlines(LUV Quote - Cramer on LUV - Stock Picks) roared ahead by 42%. Among the majors, only UAL(UAL Quote - Cramer on UAL - Stock Picks), the parent of United Airlines, was down significantly, dropping 25%.

That massive rally in the midst of a marketwide recovery after the terrorist attacks of Sept. 11 has a certain logic to it. Air traffic hasn't returned to normal levels by any means, but the rate of decline has leveled off. Domestic unit revenue now seems likely to have fallen by about 20% in November -- a huge improvement from the 31% decline in September and the 24% drop in October from year-earlier levels. And many on Wall Street think December will show further improvement. Merrill Lynch, for example, believes that the decline in December could drop to as low as 15%. With the trend moving in the right direction, investors rightly regarded airline shares as too cheap to pass up.

But now airline stocks are facing a double challenge. First, analysts worry that airlines may have seen a temporary bottom in oil prices. That would end the tumble in oil prices, caused by a weak economy, that has been one of the few factors working in airlines' favor in recent months. As of Dec. 13, the cost of jet fuel was down 46% from the same date in 2000, and it's extremely unlikely that the next year will bring anything like that kind of price decline and cost savings.

Because the price of jet fuel is the largest variable cost at any airline next to labor, airline stocks tend to move in the opposite direction from oil prices. For example, shares of Continental fell by more than $1 from Dec. 10 through Dec. 14 -- a week that ended with January crude oil futures climbing by $1 a barrel.

Second, the airlines are about to enter their slowest quarter of the year from January through March. Revenue may actually decline from what is reported for the December quarter. Going home for the holidays fills planes in December. But January, February and March are not big travel months for most Americans, and airlines typically heavily discount fares to keep planes reasonably full. (Notice how most of the current round of bargain fares requires travel by March 15 or so.)

Expect a Pullback

How airline stocks react to these two negative short-term trends will tell investors a great deal about how the stock market is developing in 2002.

In a normal year, airline stocks would pull back in the next few weeks as investors take profits and wait for seasonal weakness to present them with another buying opportunity in time to take advantage of the strong summer flying season. Wall Street analysts have in fact been recommending exactly this action in recent reports, telling their readers to sell after the run-up in shares and to repurchase sometime in the winter.

Even in this abnormal year, I think we'll see something like the seasonal pullback -- but the extent of the retreat in the prices of airline stocks will depend on the state of investor psychology. Tracking the retreat will therefore give a solid read on how investors are thinking about this market.

For example, if airline stocks retreat a modest 10% to 15% and then go back into rally mode, I think it's a sign that most investors have swung into the bullish camp. The fear of missing out on the next stage of the rally will have overwhelmed worries about buying at a temporary top. A rally from something near current prices would give support to the bullish argument that this market will go higher because there's so much cash on the sidelines that can't wait to get back into the game. And it would tell me that investors are receptive to the argument that stocks are capable of bouncing back relatively quickly to the prerecession levels of early 2001. In March 2001, Continental, for example, traded at $40 a share, and that's the current target price for the stock at Goldman Sachs as well.

It would take a much, much bigger pullback -- one that essentially took a stock such as Continental back below $15 a share and therefore near its Sept. 21 low -- to convince me that investors are still in the grip of a bearish psychology. Re-establishing the bearish price trend would require a return to something akin to panic and a renewed worry that several major airlines wouldn't survive the crunch. The unexpected failure of a major airline might push the group back to this level, and that's certainly not out of the question, considering the size of the losses that United Airlines is running currently and the rancor between management and the company's employees. But to my mind, a return to a bear market psychology requires unexpected and major bad news.

A pullback that's greater than 10% but that leaves airline stocks at or above recent support levels -- such as the current $20-a-share 50-day moving average of Continental or the $25.80 moving average of Alaska Air -- would give plausibility to my third alternative for the market in 2002. That much of a pullback -- 20% or somewhat more -- would suggest that investors remain sufficiently leery of this market and significantly sensitive to valuations to sell into temporary tops. A pullback of that size would also suggest that the price volatility of the market is sufficient to justify an intermediate-term contrarian strategy of buying and selling profitable sectors. Anything less makes it too hard to catch the move before it's over. Anything too much more than that raises the possibility of real losses if the pullback turns into a rout.

I'd like to see that kind of orderly pullback, consolidation at support, and then a renewed move upwards in airline stocks for two reasons. First, it would let me make some money by buying likely strong performers such as Alaska Air and Continental. Second, it would argue that 2002 might mark a return to a relatively predictable and orderly stock market. Not one that necessarily produces huge returns but one that could result in a solid profit.

And that would be very welcome indeed after 2001.