XTN: Small-Cap Transportation Stocks Have Likely Run Out Of Road

The SPDR Transportation ETF (NYSEARCA:XTN) is an equal-weighted index of all of the stocks in the S&P Total Market Index that fall within the following subindustries: Air Freight & Logistics, Airlines, Airport Services, Highways & Rail Tracks, Marine, Marine Ports & Services, Railroads, and Trucking. In this article, I am going to explain why (a) transportation stocks have a modest chance of outperforming the broader market over the remainder of the decade, but (b) will likely see very low returns nonetheless, and (c) are at risk of a sharp cyclical downturn over the next one to three years.

The ETF is composed of 50 stocks with holdings at present ranging from 3.1% for the top holding to 0.7% at the bottom and 2% on average. Unlike large-cap sectoral ETFs, there tends to be a lot of jostling for position within the index from month to month. In order to anticipate how a herd of cats like this will behave over the long- and short-term, I prefer to see how that herd of cats has behaved in the past.

To do that, I sorted XTN’s holdings by SIC code (you can find those on the SEC’s website) and then cross-checked those SIC codes with the Fama-French database, which creates industry- and sector-level indexes based on SIC codes that usually go back to 1926.

Below is a table with the top 20 holdings and the respective companies’ GICS subindustry and their Fama-French 49-industry classification.

The vast majority of these stocks are classified as Transportation. Indeed, by my count 85% of the ETF’s holdings are Transportation, 13% Services, and the remaining fraction in Aircraft and Software.

The GICS classifications are more granular, and you can see subindustry weightings in the following chart from State Street Global Advisors (linked to in the first paragraph). Most of the XTN holdings that are classified as Business Services or Personal Services by Fama-French come out of the Trucking subindustry (roughly a third). Even though Shipping companies currently make up the top four holdings of the ETF at present, the subindustry as a whole only makes up about a tenth of this transportation index.

In any case, we are going to begin with an overview of the historical performance of equal-weighted Transportation stocks and see if that suggests any clues about possible future performance.

Long-term performance of transportation stocks

The following chart shows the performance of cap-weighted and equal-weighted transportation stocks relative to the S&P Composite since 1926 (data from Robert Shiller).

Since the Depression, there has been a wide divergence in the relative performances of the large- and small-cap Transportation indexes, but over shorter durations, their relative performances have tended to correlate.

Relative to Treasury bonds (data from St Louis Fed and Shiller), they have outperformed since the Depression, but their relative rates of growth have diminished since the late 1960s.

A key metric for studying stocks, in my opinion, is how they behave under conditions of commodity inflation and deflation or when the broader market is in a “secular” bull or bear market.

Small-cap transportation stocks are first and foremost small caps

Depending on how you read Charts B and C above, the heyday for small-cap Transportation stocks ended either around 1968 or 1983.

The problem with small-caps is that they follow rules that are somewhat different from large caps. Large caps, for example, do not like commodity inflation, but the chart below suggests that Transportation small caps do best when there is long-term reflation in commodities and the broader equity market. They do not seem to do especially well at periods of peak commodity inflation (e.g., the late 1940s, the early 1970s, the late 1970s, the late 2000s and early 2010s) or periods of declining momentum in the S&P Composite, but it is quite difficult to come up with simple rules of thumb for Transportation small caps.

Sources for how I compiled this Historical Commodity Index can be found in How And Why I Am Breaking My Rules For Commodity Trading.

In my most recent overview of the size effect over the last century, I found that almost all periods of major small-cap outperformance occurred during “secular” bear markets in large-cap equities, as can be seen in the following chart.

The following chart shows the long-term total returns performances of small-cap Transportation stocks (in blue) and an average of small-cap sectors (in orange) relative to the S&P Composite.

Small-cap transportation stocks are highly correlated with the expression of the size effect in the market as a whole. But, it has to be noted that during the Depression, small-cap Transportation stocks had trouble keeping up with the broader market.

Since my models point to Depression-like outcomes in the 2020s to be led by a sharp cyclical downturn over the next two to three years, these small-cap Transportation stocks may be less likely than other small-caps to outperform this decade, which in turn suggests it would not be prudent to take a long-term position in Transportation small caps until after a considerable absolute market-wide decline.

The following chart shows that every major stock market decline over the last century except one (the crash in the early 2000s) has seen extreme cyclical underperformance of small-cap Transportation stocks.

So, all of the worst sell-offs occurred during “secular” bear markets in the benchmark indexes like the S&P 500. Yet, the “secular” bear markets were periods of long-term outperformance by small caps, including small-cap Transportation stocks. By extension, the best time to buy small-cap Transportation stocks is at the cyclical bottom of a “secular” bear market. The only occasion where that would have led to a missed opportunity is the small-cap boom of the 1960s, which seems to have somewhat anticipated the bear market, but those conditions do not seem to be present now.

Valuations in small-cap transports do not appear to be predictive

I do not have long-term data on Transportation stock earnings, so I cannot determine what historical PE ratios were, but dividend yields are often a close approximation, if one keeps in mind that dividend growth has tended to be lower than earnings growth since the 1950s.

I calculated the historical dividend yield for small-cap Transportation stocks by contrasting total returns and price returns.

Perhaps the rise in the dividend yield points to higher returns, but there is only a very weak correlation between the two (0.25 between the yield and total returns).

There is a slightly higher correlation between the dividend yield and the subsequent performance of the dividend side of the fraction.

High yields point somewhat to the slightly increased possibility of low to negative dividend growth.

In the Seeking Alpha chart below showing XTN’s dividend yield relative to the S&P 500’s, we can see the curious rise in small-cap dividend yields since 2007.

If we contrast price returns and dividend growth, as in the following chart, we can see that the rise in the yield is due to a secular decline in the growth rate of prices and a secular rise in the rate of dividend growth. Historically, there has been something of a correlation between price performance and dividend growth, but it has diminished since the 1970s.

The change in the relationship between dividends and price over the last 15 years is much less apparent in Transportation large caps, so it is difficult to say where this change is coming from or what it means.

The recent rise of small-cap dividend yields appears to be unprecedented. This is the first time it seems to have exceeded large-cap yields (as seen in the chart of the cap-weighted transportation index (IYT) below).

That leads me to suspect that this is primarily being driven by the pandemic and its aftershocks and may not be meaningful. But, it does seem that this gap was already being narrowed well before the pandemic.

It’s the macro that matters

Ultimately, I can find no consistent relationship involving small-cap Transportation stocks and their dividend yield. Rather, the macro relationships involving broader large-cap and small-cap patterns seem to be more salient.

Historically, seven-year outperformance by tech stocks relative to the other sectors, especially when paired with marked energy underperformance, has been followed both by the exact reverse pattern (that is, energy outperformance and tech underperformance) over the next seven years. Moreover, this has historically been paired with low returns-i.e., “secular” bear markets-in the benchmark indexes over the same period. And, “secular” bear markets are highly cyclical: equities behave as if they were commodities and cyclical stocks (like energy) outperform. We can layer on top of that outperformance of small caps, but we must remember that small caps are also highly cyclical. That means that the best way to gain exposure to the size effect is to wait until the cycle has bottomed.

Lately, I have been working on a separate and more complex and dynamic system of indicators for small caps that appears to be predictive of subsequent relative performance in that space. I am not prepared to present that quite yet, but that system suggests that the size effect may not be ready to kick in until 2024, which roughly confirms my other research linked to above pointing to a strong cyclical bear market until about that time.

Conclusion

At present, XTN’s technicals do not appear especially weak. It is currently smack in the middle of its 52-week range, but this is nonetheless a serious reduction in cyclical momentum.

I do not know what the short-term fate of these stocks will be-nor do I know their long-term fate-but it appears to me that, because of macro-market conditions, the preponderance of long-term risk (until the end of the decade) for the XTN is to the downside, and especially over the course of the next one to three years. Once that cyclical storm is past, perhaps after the ETF clears its 2020 lows (roughly half of its current value), there may be considerable risk of outperformance in these small caps.