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Airlines Look Priced for Perfection

Of all the equity sectors I track globally in order to gauge immediate economic prospects, the sector that stands out currently is the U.S. airline industry.

The major airline stocks are all ripping higher today and have been doing so over the past six months. American Airlines (AAL - Get Report) is up 4.5% today alone and 65% in the past six months. Delta Air Lines (DAL - Get Report) is up 1.8% today and 50% in the past six months. United Continental Holdings (UAL - Get Report) is up 2% today and 33% in the past six months. Southwest Airlines (LUV - Get Report) is up almost 3% today and 50% in the past six months.

This level of appreciation has sent the price-to-earnings ratios for the sector to levels that in the past would have been associated with technology growth.

American, Delta, United and Southwest have current price-to-earnings ratios of 26, 13, 23 and 25. A long-term trend for the industry, which is mature, is in the range of 10. Only two of these four pay a dividend, Delta and Southwest, both at a low 0.8%.

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Everything is indicating that the stocks of these companies are already priced for no consideration of an economic slowdown over the next several years.

The general consensus in the financial media is that consolidation within the industry is going to return pricing power to a reduced number of participants and that travelers will pay up by necessity.

One of the problems with this scenario is that, consolidation aside, since the financial crisis of 2008, passenger miles traveled per capita in the U.S. have not recovered. In 2008, the rate of growth in airline travel peaked at about 10%. After the financial crisis, this abruptly dropped to about minus 3% in 2009. Growth has since recovered to 0%, where it remains today.

The airlines are all buying their fuel forward, while oil is in the $80-$100 range, and booking these prices as a hedge, indicating that they uniformly believe that oil prices, and thus fuel prices, will only rise over the next few years.

When airlines bought their fuel forward in 2009 and 2010, while oil prices were in the $40-$60 range, where prices had fallen after the financial crisis, that was beneficial to their bottom lines. Locking in now at $80-$100, rather than being a hedge, may very well prove to be a catastrophic speculation if economic activity slows or contracts and oil prices fall again.

Even if that doesn't occur, the stocks of the airlines are already reflecting expectations for growth in economic activity and thus passenger miles traveled. Anything that causes those expectations to change could cause the prices of these stocks to plunge.

We don't own any of the airline stocks, because they do not meet our criteria for either growth or income. However, the recent appreciation performance has been stellar for holders of these stocks. At this stage, the most prudent course of action for speculators, in my opinion, is to sell them, take the profit and wait for the correction, which I believe is more probable than not.

At the time of publication, Arnold had no positions in stocks mentioned.

Roger Arnold is the chief economist for ALM Advisors, a Pasadena, Calif.-based money management firm specializing in income-generating portfolios. Concurrent with his other business responsibilities, Arnold was a radio talk show host for 15 years. He focuses on behavioral economics and chaos theory, better known as the "butterfly effect." He explains the relationships between political, economic and social systems, and how they are all reflected in the financial markets -- stocks, bonds, commodities, currencies and real estate.

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