How to Leverage the Worst Business in the World

Today I am going to tell you about the most disastrous business model in the world — an entire sector of well-known blue chip companies that, so far as I can tell, exist solely to separate fools from their hard-earned money.

I will tell you why these companies are most probably screwed…

And then — as promised last week — I will tell you how to how to steal away a sizable chunk of cash when they go down in flames.

High Tech Fail

This is an ultramodern high-tech biz run by hardcore entrepreneurial captains of industry. It has always incorporated the absolute latest developments in engineering and software. It has literally changed the entire world in a mere 50 years.

But the harder these guys work, the more sales they make, the worse off they are.

Seriously, I have on my desk in front of me an eleven-page list of all the companies in this well-known trade that have crashed and burned since the biz got off the ground back in the 1930s.

The problem is this business has a mortal enemy, a parasitic “Black Tide” that systematically drains away profits before they even really happen, leaving behind hollow shells doomed to failure…

Wall Street Pump Job

Wall Street is actually pumping these stocks up these days, talking up cherry-picked statistics like U.S. Airways’ recent report of a 4.1% increase in traffic last February compared to February of 2010. And for a while there, the airlines did quite well off this steady drum beat, with some prominent players gaining as much as 7% or even 8% in a single day.

This is a damn shame, because these stocks are particularly at risk right now.

My technical charts indicate that the entire group stands to lose as much as 32% of its value over the next three months.

But that’s alright — because I will also tell you how to leverage this “wisdom gap” into double-digit gains (maybe even triple-digits, if these guys take a tumble like I figure they will).

Extra Bonus: A Decent Detroit Story for a Change

And then, just to keep things from getting too damn grim, I will tell you about a classic American blue chip company that’s dancing on its competitors’ graves.

It looks like it is ready to put on another 39% over the next three months.

That’s not too much of a stretch, mind you — it’s already put on 1,778% plus over the past couple of years.

First the Bad News…

I’ll confess that I’ve been coy so far this week, painting a crappy picture without revealing exactly who I am badmouthing. Frankly, Wall Street is pushing these guys right now, so I wanted to make sure you are on board with me before I tip my hand…

I am talking about airlines.

The airline biz is relatively straightforward. They buy airplanes — that’s their primary capital expenditure.

They pay labor: pilots to fly them, attendants to herd folks in and out of their seats, mechanics to fix the planes, clerks to sell tickets and explain to folks in line why their flight is delayed, and baggage handlers to destroy the luggage you were foolish enough to entrust them with.

They rent real estate in the form of landing slots and passenger gates at airports, and the right to fly over real estate.

The Kerosene Rub

But the one big expense on an airline’s balance sheet just has to be kerosene — the jet fuel that keeps the planes in the air.

The International Air Transport Association (IATA) estimates that since 2003, fuel’s piece of the airlines’ pie has nearly doubled. In 2011, fuel will account for some 29% of airline operating costs.

It doesn’t take much stress to upset this industry, as it operates on a razor-thin margin of net profit of roughly 1.4%… Needless to say, spiking fuel costs has the airlines’ knickers in one hell of a knot.

If crude oil rises no higher than an average $96/barrel for the year, the IATA figures its members’ net profits will backslide some 46% in 2011. Problem is, it’s only March — and crude oil has already bashed its way through the $100/barrel barrier.

Right about now, folks tend to whine at me about airline fuel futures, and how they inherently protect airlines from losses. Please understand that these sort of contracts are not some sort of a magic bullet. Even when they work as planned, they still carry a substantial speculative premium in this spiking oil market.

And I’ve heard tell of botched hedging plans seriously impacting the bottom line.

Beat Down by the Black Tide

The airlines’ catch-22 in a nutshell? Every time the economy looks up, airline sales volume starts to increase.

Problem is, the oil speculators at NYMEX are always two steps ahead of the airlines, driving up crude oil and jet fuel AHEAD of any airline profits’ uptick.

In essence, volume equals death for airlines.

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Here is a chart mapping airline bankruptcies against oil futures for the past 25 years.

Note that these guys did reasonably well when oil ran flat for a decade; but when oil began its climb to the stratosphere, airlines began dropping like flies.

You want to see something counterintuitive? Check out the run post the 2008 crash, when banks were collapsing like wet paper bags, and car company execs were shuttling between Detroit and Washington begging for the capital to stay open.

Not a single airline went under during the big crash… But five have gone bankrupt since oil began climbing again in 2009!

Strategic Airline Proxy
 

There is a convenient way to gauge — and ride — this industry’s next downside slide: the Guggenheim Airline ETF (NYSE Arca: FAA ) bundles together several of the top players in the trade into a single basket.

And while there is no guarantee that any one of these guys in particular will be the next to drown under the Black Tide, you can bet that the group as a whole will take a severe hit on the news.

click to enlarge

And indeed, we already see the technical signs that indicate the end of FAA’s recent long-term bull trend. Price is now consolidating below the critical node at the bottom of the rising price channel, the 200-Day Moving Average, and the Fibonacci (F.) -23.6% marker. From this point…

• Probability of a test of the 38.2% marker at FAA $$36.06 is extremely strong;
• A continuation to F. -50%  at $28.50 is reasonable;
• And it’s just quite possible that we could see the pattern finish out at the F. -61.8% marker at $24.74 for a total loss from current prices of some 32.11%.

Short Side Tactics

Here’s your tactic for leveraging this scenario: Buy the FAA June 37 Put Option (FAA1118R37), currently trading for 2.85 with a Delta of 0.4957.

Should FAA come to that first target of $32.06, these puts could be expected to hit $5.03 for gains of some 76%.

Now that’s probably a fine place for any normal person to sell, but if you really want to know what’s possible here, FAA’s extreme target of $24.74 would drive that put to $8.66 for gains of 204%.

And Now for Some Good News…

I was speaking with my friend Jeff Siegel the other day about the stories coming out of Japan, and he asked me to be sure and tell you about one particularly exciting scenario wherein the death of the Japanese auto industry does a real favor for Detroit.  

Much of Japan’s production capacity is offline right now. In many cases, inventory at dockside has been damaged. Chain of supply for parts is in shambles. And the ability to move heavy cargo offshore is certainly off.

Here in the States, prices are rising rapidly for whatever inventory was en route when the disaster struck.

For an organization like Ford (F: NYSE), this is a godsend. They have been working their tail off for years now to develop a decent line of fuel efficient hybrids and standard compacts (unlike, say, GM, who just started down this path some eight months ago).

Ford will now have a chance to move right past both their fellow U.S. competitors — and their Japanese competitors as well.

Add in the Fed’s propensity to keep borrowing rates rock bottom during this period of uncertainty, and you can see why F shares ought to have a decent tailwind for a month or three.

Next week, I’ll walk you through Ford’s technical chart, but I will tell you right now that a 39% rally is certainly possible. The proper call option should enable you to leverage that rise into 291% gain.

Yours Truly,

Adam Lass
Editor, Wealth Daily