After a brief consolidation in March and April, industrial stocks and the transports are headed back towards their highs or higher. 3M Co, Union Pacific, Honeywell Intl, Boeing Co, Deere & Co, GATX Corp, CSX Corp, Kansas City Southern, Alaska Air, Norfolk Southern, and many other mid- and small-cap companies within the sector are touching all-time highs or breaking out. By reviewing the charts, it is clear that there is a new secular bull market in America’s Industry.
Part of the recent run in industrials can be explained by the resurgence of the risk-on trade. Defensive sectors had a nice run in the latter half of the first quarter and the beginning of the second quarter due to slowing economic activity and concerns the Fed might taper its purchases; however, now they’re becoming a source of capital to buy the cyclical groups. As shown by the ratio chart of the Morgan Stanley Cyclical Index to the Morgan Stanley Consumer Index, the current leg up in the market has been sponsored by the growth-sensitive cyclical stocks of the market.
We can also see the change in risk appetites as displayed by the two Risk-On and Risk-Off ETNs by ETRACS. Since February, investors were in favor of shorting cyclical assets in energy, agriculture, metals, equities, commodity currencies, and, instead, buying Treasuries. The trend has reversed and investors are more in favor of cyclical assets and global growth.
There’s no doubt that the change in risk appetites has stemmed from a change in Fed-speak. The attitude on the Federal Open Market Committee had changed from taping QE to allowing it to remain. Some of the more dovish voters like Evans even called for a change in the Zero Interest Rate Policy target from 6.5% to 5.5% in one of his April speeches.
Besides a change in Fed-speak, we’ve seen the leading economic indicators begin to lift up again as shown by the ECRI’s Weekly Leading Index (WLI) and their Coincident Index. Part of the rebound in the WLI might be explained by the reduction in commodity inflation by the pullback in copper, iron, and crude oil over the last few months; however, that trend has changed mid-April.
Source: Business Cycle
When it comes to commodities and global growth, I look no further than the Chinese Shanghai. If the Shanghai Composite continues its downtrend, this is merely a bear market rally in commodities and cyclical stocks. Chinese stocks had a magnificent end to 2012 that spilled into January as manufacturing recovered; however, that reversed in February along with the any risk-on and pro-growth movement in U.S. cyclical stocks and commodities. The current rally in May has run up against three significant resistance levels. The first is the declining intermediate-trend that began in February. The second is the breakdown in support near 2250. 2250 has rebuffed two separate rallies in April and it could rebuff the current rally this week. The third is the declining 50-day moving average. A break above all three would be a bullish inflection point for Chinese stocks and a boon towards commodities and cyclical stocks.
The HSBC Purchasing Managers’ Index for China’s manufacturing and services data has shown that growth is very slow and fragile in 2013. The final PMI composite for China’s manufacturing in April showed very slight growth at 50.4, which was below the March number (51.6). An accelerating Chinese economy and stock market would represent the best situation for industrial stocks and commodities, but the rally in the stocks I listed in the opening paragraph show that China isn’t the only driver behind earnings.
Accommodative monetary policy has brought interest rates down to record levels. The same catalyst of cheap debt refinancing for utilities, which has widened profit margins, also affects capital intensive industrial companies. Cost of capital has dropped and huge interest rate expenses have dropped significantly in the last three years.
Q1 Earnings
What did we learn about Q1 earnings? 88% of industrial companies missed top line estimates. 50% missed EPS consensus and 63% had negative earnings revisions according to a Barclays report on the sector. Despite the worst quarter since 2Q 2008, portfolio managers remain bullish on the S&P and so they’re bullish on Industrials. Higher yielding large-cap names are on more buy lists than the non-yielding industrials. Only four companies raised their 2013 earnings guidance (LII, TYC, HON, and AME).
Railing Right Along
The rails have been a strong point in the industrial complex for some time. Rails have been a very strong benefactor of the fracking revolution. Despite lower coal and grain shipments, down 6 and 9% respectively, companies like Union Pacific (UNP) showed first quarter profit up 11% on an increase in shipments for chemicals (14%), automotive (13%), intermodal (9%), and industrial product (6%). Union Pacific said there is still a lot of uncertainty about 2013, but the flexibility of their company allows for them to adjust to the tempo and demand of American industry.
Conclusion
Industrials have reasserted their market outperformance in the latter half of April along with commodities and other cyclical sectors like technology, energy, and basic materials. This is the return to the beta trade that was given up during February, March, and the first half of April. Personally, it seems like a trading fad that isn’t being backed up by economic growth and revenue growth. If it’s based on the temporary shift in Fed language that has postponed tapering QE until the second half, then what will happen when the next Federal Reserve member speaks out about tapering QE again (something rumored about today)? While industrials lost some alpha in the second half of Q1, the charts still look phenomenal. Low cost of capital and slow growth has been good medicine for industrial price multiples expansion. The moral of the story: follow the charts and not the fundamentals. That’s to say that the move back into risk assets is most likely a technical trend and not a fundamental one. This continues to belabor the point, that we shouldn’t “Fight the Fed”.
