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.
Until recently, the industrial cyclicals, which include aluminum,
chemicals, metals, steel and machinery stocks, had been in a trading
range that dated to late 1996. The overall market, by contrast, has
soared over the same period.
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.
Smelting stocks have been heating up, for good reason.
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.
Table: Nifty Forty?
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. |
