April 26, 1999
Basic Truths
Long-run economic outlook justifies revival of cyclicals
By Gene Epstein
At some point over the next five years, the U.S. economy may falter. But the
setback is likely to be short-lived, and the long-term expansion that began in 1982
should persist. And over the same time frame, the economies of the rest of the
world will be in much better shape than today. In fact, the faltering tigers of Asia
should be back in high gear.
That scenario for the global economy seems more plausible than any other -- far
more so than the thick gloom that pervaded the analyst community only six
months ago. And it perhaps best explains the sudden revival of industrial cyclical
stocks.
The chart on this page
puts their recent rally in
perspective, revealing
the long-term disconnect
between these stalwart
stocks and the overall
market. For these
old-fashioned industrial
cyclicals, it stands to
reason their share prices
will appreciate
handsomely as the
market begins to
discount the expansion
phase of a business
cycle.
For all the talk about the
shift to service-based
consumption, we tend to use a lot more aluminum, chemicals, metals, paper, steel
and machinery when the economy is on an upward path. This pattern is even
more pronounced in the emerging-market countries, whose economies are still in
the industrializing stage of development. Moreover, these industrial goods are
freely traded across borders, making the global economy the key determinant of
these businesses' vibrancy.
As the chart shows, through early 1993 through mid-'95, the index of 40 stocks
that we've defined as the industrial cyclicals actually rose faster than the S&P
500. This bull market continued through mid-'97, only to go into a trading range
as the Asian economies began to unravel.
The recent rally that took off early this month was fueled by more than just a
capricious rotation into these stocks. As First Call research director Charles Hill
points out, much of it was a legitimate response to a shift in sentiment by the
analysts who watch them.
This shift in sentiment has some intriguing history behind it. Fourth-quarter '98
earnings for most of these companies actually topped forecasts, Hill notes. But
such was the pessimistic a view at the time that the analyst community responded
to this performance by lowering their estimates for the first quarter.
But now that first-quarter
earnings again are running
ahead of estimates, analysts
have begun singing a very
different tune. Instead of
cutting their numbers for the
second quarter, they've been
raising them, helping to spur
the rally.
At least that's been the pattern
so far for paper, aluminum,
steel and other metals
companies. On Thursday, Dow
Chemical soundly beat the
numbers, and analysts duly
raised their second-quarter
forecasts. Hill looks for more of the same when additional industry numbers
come out this week. As a harbinger, Union Carbide last month preannounced that
first-quarter earnings would beat analysts' forecasts.
As for the machinery stocks, the table shows that they've been rising at least as
smartly as the others on the list, although the fundamentals say they should be
lagging the commodity-based companies. That's because, just as the economic
contraction hit metals, chemicals and paper a good two quarters before
machinery, the anticipated pickup should benefit that industry a good two
quarters later. So analysts haven't been raising their quarterly earnings estimates
for these companies, and aren't likely to for some time.
That's probably the reason why analysts aren't
especially keen on this group as a buying
opportunity. But then again, in response to First Call's standard question to
analysts about whether they'd buy, sell or hold with a 12-18-month time horizon,
none of these industry groups gets an especially high rating.
The upward revision in earnings estimates hasn't been accompanied by a similar
upward revision in rating recommendations, presumably because analysts believe
the rally has discounted the improved earnings prospects. The highest-rated
industry of the lot is steel, which gets a 2.2, according to First Call's method of
quantification. That puts this industry technically in buy territory, although no
more so than S&P 500 companies as a group, which also gets the same 2.2. As
noted, the other industries on this list fare even worse.
But if analysts have been reluctant to view the industrial cyclicals as buying
candidates, one might chalk that up to the tendency to be behind the curve when
matters have been looking bleak. And to get back to the bleak reality, while
earnings have generally been looking better for these stocks, one must bear in
mind the virtually across the board, earnings are projected to be flat to lower for
calendar year '99.
So it may be premature to consider buying these stocks. But timing is always a
fine art, and especially with a five-year outlook, it's better to be too early than
too late. In that regard, Carl Weinberg, chief economist of the Valhalla, New
York-based High Frequency Economics, notes signs of an early dawn. Based on
last week's report for the month of February from the Commerce Department,
exports to what Weinberg calls the "five falling tigers" -- Korea, Thailand,
Malaysia, Philippines and Indonesia -- were up from the same month a year ago.
Weinberg also anticipates that at some point in the next five years, this swing
region will be back in vogue and growing at "developmental" rates again. If that
happens, and if the rest of the world sees reasonable prosperity as well, then the
earnings of the industrial cyclicals should participate in those good times, with all
that implies for the price of their shares.
With a five-year time-frame in mind, Morgan Stanley metals analyst R. Wayne
Atwell would be a buyer right now of Phelps Dodge and would look to buy Alcoa
at a more attractive price in the not-too-distant future. |
