*OT*Haim:WSJ::" Cyclicals Are Stuck In a Three-Year Rut.
June 26, 2000
Cyclicals Are Stuck
In a Three-Year Rut
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
If you are feeling blue because your once-hot New Economy stocks are in the doldrums,
spare a moment for Old Economy stock investors: Many haven't made money for three years.
Despite one of the strongest spurts of economic growth in recent memory,
economically sensitive stocks are no higher today than they were in June 1997.
"Cyclical" stocks' short spell in the sun between March and mid-April has evaporated.
Consider that after Honeywell International, a diversified manufacturer formed by the merger
of AlliedSignal and Honeywell, warned last week that its second-quarter profit wouldn't match
analysts' estimates, its stock fell to $34.6875 at week's end, back to a level it first topped in November 1996.
The story is worse for the truly deep cyclicals, such as forestry products and metals companies.
International Paper is trading at the same level that it stood at in 1991.
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To be sure, some of this recent weakness reflects signs the economy is slowing from its
breakneck growth pace, in response to the Federal Reserve's series of interest-rate increases
that began last summer. That doesn't explain why cyclical stocks have made no progress in the past three years,
a period in which growth in gross domestic product raced along at more than 4% a year.
Something more fundamental is happening. Business spending in the past three years has been
concentrated on productivity-boosting, cost-cutting technology. Demand for either basic commodities
other than oil or traditional manufactured goods has been much more modest. "Capital continues to flow away
from physical businesses to knowledge-based businesses, and there's an ongoing recognition, by the markets,
that information is more valuable than physical assets," says Michael Mauboussin, chief investment strategist
for the investment bank Credit Suisse First Boston.
Increased productivity and a vigilant Federal Reserve have put relentless pressure on prices,
one of the avenues through which cyclical companies traditionally boosted profits.
"We've had a religious fanaticism about avoiding inflation," says Tom McManus, portfolio strategist
at Banc of America Securities. "And what's good for the overall economy, a low inflation rate,
has been disastrous for investors in companies that rely on price to drive earnings gains."
Indeed, James Paulsen, chief investment officer at Wells Capital Management, says that
until the mid-1990s, strong economic growth consistently enabled cyclical stocks to
outperform the broad market. That pattern has broken down. Since June 1997, the Morgan Stanley
cyclical stock index is unchanged, while the Standard & Poor's 500-stock index is up 31%.
The reason? Mr. Paulsen says the underperformance in cyclical stocks tracks a corresponding
decline in commodity prices. "You've had a surge in GDP, but very little recovery in raw industrial prices.
And cyclical areas of the market have responded more to pricing than real GDP."
Investors expect Federal Reserve policy makers will decide not to raise interest rates at this week's
meeting, but that is little cheer to cyclical stocks: The decision would be motivated by signs
that the economy is slowing and inflation is under control.
The pressure on cyclical stocks has taken a toll on the Dow Jones Industrial Average,
in which such stocks have proportionately more influence than they do in the S&P 500 or
the Nasdaq Composite Index. The Dow industrials barely budged last week to end at 10404.75,
which is down 1.4% from 12 months ago. By contrast, the Nasdaq composite, even after dropping
91.50 points, or 2.3%, to 3845.34 Friday, leaving it down 23.8% from its March high, is still up 50.6% from a year ago.
Cyclical stocks' performances are taking a toll on their believers. "This sector has become so small,
some people have thrown in the towel and don't want to invest in it," says Scott Schermerhorn, head
of the value-style investing team at Colonial Management Associates. "Value" stocks trade at lower prices
relative to earnings or other measures than do "growth" stocks. "They don't believe it's an investable group."
One sign of the lack of interest: He says Prudential Securities no longer has analysts covering cyclical industries
such as paper and forestry products, steel and metals. A Prudential official didn't return a call seeking comment.
Mr. Schermerhorn says many cyclical companies owe their weak stocks to management mistakes.
He dumped his International Paper shares when the company paid what he considered an excessive price to acquire
Champion International. He put the money in Georgia Pacific, but it trades at the same price it commanded in 1989,
which works out to a measly four times next year's estimated earnings. Honeywell has shaken investor confidence
with the abrupt warning so soon after its merger. As a result, its stock is no higher than it was in 1996 despite expectations
(even with the latest warning) that profit this year will be 76% greater, according to First Call/Thomson Financial.
Cyclical companies can't compete with technology companies for investor enthusiasm, in part because their markets are mature.
"Their demand for products is more related to the number of people who can buy them, and not to any extraordinary
build-out like fiber-optic cable," Mr. McManus says. It is much easier for investors to imagine Cisco Systems or
JDS Uniphase doubling sales, than General Motors. Thus, they pay more than 100 times this year's estimated earnings
for Cisco and JDS Uniphase, but just six for GM, whose stock stands no higher today than it did in early 1994.
Some Old Economy companies have broken away from investor disenchantment by raising the "knowledge"
component of what they produce. "We make this generalization, that cyclical stocks have done nothing,
then we see companies like General Electric, which has been on the forefront of the transition from physical assets
to knowledge," Mr. Mauboussin says. GE, he says, aims to derive 60% of the revenue in its manufacturing businesses
from services instead of hardware, compared with 20% five years ago.
Such efforts aren't always successful. "For a long time DuPont said, 'Don't value us as chemical company,
value us as life-sciences company,' and for a while we did," Mr. Schermerhorn says. But even though DuPont
paid heavily to add to its life-sciences strength, it has done little to energize earnings, which this year
are expected to be 9% below that of 1996, according to First Call. "So far, [DuPont] hasn't delivered.
So now we value them again as a chemical company."
DuPont's fall from grace has been especially striking. At the end of 1996, it was the 15th-most valuable company
in the S&P 500; today, it is No. 63, and is worth less than Yahoo! |
