On January 26, 2016, we posted an article about Union Pacific Corporation (UNP). In that article, we made the case for the stock based on the distinction between a parabola and stock cycles. The basis for our claim lies in the work of Charles H. Dow’s view on how and when to use market data. According to Charles Dow:
"The point of importance for those who deal in industrial stocks is whether the capitalization of the companies into which they propose to buy is moderate or excessive, when compared with the aggregate earnings of the various concerns forming the combination in a period of depression. It is probable that consolidated companies will be able to earn as much in the next period of low prices as the companies forming the combine were able to earn in the last one; hence the very foundation of investments in industrials should be knowledge of what these companies earned, say in 1893 to 1896, making, perhaps, reasonable allowances for economies under consolidation. Where the earnings so shown would have provided dividends for industrials now active, the fact must be regarded as a very strong point in favor of those stocks (George W. Bishop Jr., Charles H. Dow: Economist, Dow-Jones & Company,Princeton, 1967, page 11.)"
Essentially, Dow suggests that the most compelling data is derived from when the stock experiences its worst performance, generally during a prior recession or depression low. Looking at UNP from 1980 to 2015, we determined that the six periods (from peak to trough) in the stock price was more instructive than taking into account the entire period as a whole. Our conclusion:
“The repeated pattern of declines greater than –30% is no coincidence. These are the apparent cycles that UNP happens to experience. Furthermore, the level of consistency for UNP to decline on average –48% over the period from 1980 to 2008 (7 data points) indicates that this is very useful in determining what is “normal” for the current decline in the stock price. Already UNP has fallen –43.16% which is generally in the sweet spot as we believe that the 2008 and 1980 declines were outliers in especially painful recessions.”
Since our January 26, 2016 article, Union Pacific Corporation (UNP) has increased in price by +57%. Now, it must be said that such astronomical returns by a hum drum railroad company should not be expected to be normal. At some point, there will be a reversion to the mean which includes the possibility of the stock price stagnating while the Dow Jones Transportation Index increases or declines at a greater rate than the Dow Jones Transportation Index in the next bear market. That being said, let’s look at what to watch going forward.
Charles Dow outlined what is known as the 50% Principle. This concept indicates that an investor reviews the previous major rising or declining trend to determine the upside and downside targets. Dow elaborates in detail the reasons why the 50% Principle is a meaningful reflections of expected investor behavior.
Our use of the 50% Principle has primarily been for assessing downside risk. However, we can also us it for the benefit of determining upside potential. In the case of Union Pacific Corporation (UNP) we have outlined the level of the 50% Principle in the red dashed lined in the chart below.
Anyone interested in UNP at this point should accept that in the more conservative scenario, UNP could go as high as $124.52 ,which is only a +15% gain relative to the increase that has already occurred (+57%) since our last article on the topic. While the optimism that has projected the stock price higher can continue beyond the $125 level, it would be considered a gamble not worth pursuing, from a value standpoint.