Industrial stocks steal the limelight
News Analysis: Is the current fashion for more economically sensitive, cyclical stocks anything more than a fad?
Thursday 22 April 1999
Since the beginning of April, share prices in the UK chemicals sector has jumped by more than 20 per cent, while engineers have added around 15 per cent to their value. It seems that investors just can't get enough of the industrial blue-chips. Shares in the persistent market underperfomer ICI, for example, have leapt by over 20 per cent since the start of the year.
The recent performance of so-called growth stocks, by contrast, has been dire. Pharmaceuticals, telecoms and IT companies have all seen valuations plummet. Does this shift from growth stocks into cyclical, or economically sensitive, industrial stocks mark a sea-change in market sentiment? Or is it just a knee-jerk reaction to the phenomenal surge in share prices enjoyed by high-tech stocks in past months?
The answer, according to market strategists, is a bit of both. Since the beginning of the year, investors have become increasingly jittery about the valuations attached to high technology stocks - particularly US Internet stocks. "People are starting to feel nervous about things in their portfolio that are on 50-times earnings," says Bob Semple, a BTAlex.Brown strategist. "With that sort of stock, you're taking a lot on trust."
With that in mind, dealers have been nervously watching for signs of deteriorating earnings potential in the technology sector. They did not have to wait long - recent high-profile earnings warnings from IT companies such as Compaq gave the market the excuse it needed to divert funds elsewhere.
Technology shares all over the world have dropped in the wake of the Compaq debacle, with the Nasdaq Composite, the benchmark US high-technology index, suffering one of its steepest falls in history.
But there's a bit more to the recent switch from growth stocks into cyclicals - so-called "portfolio rotation" - than nerves about high-tech stock prices. All sorts of stocks that are generally bought for their growth potential - such as pharmaceuticals and telecoms - have fallen out of favour in recent weeks. Surveys of investor opinion have started to show widespread disillusionment with growth sectors. There has been, according to the experts, a shift in some of the fundamentals.
Richard Batty, an HSBC Securities strategist , says: "It's not just a short-term reaction. People are starting to upgrade their global growth forecasts and that opens up the prospect that the outlook for cyclicals won't be as bad as previously thought."
Mike Young, a strategist at Goldman Sachs, agrees: "We believe this reflects a dramatic shift in risk perceptions. Until January, there was a fear of global deflation and recession, and some of the industrial cyclicals were priced as if there was a risk of bankruptcy. Since the end of January, however, these global risks have dissipated."
In short, the renewed bout of confidence in global economic prospects has sparked a re-rating of industrial stocks. Consumer-based stocks, such as hotels and retailers, have also benefited. "With interest rates coming down, I'm more convinced the UK consumer can start spending again," says Mr Semple.
Where do we go from here? Most of the experts believe the rush for cyclical stocks at the expense of growth stocks is little more than a short-term phenomenon. Once the dust has settled, earnings potential will again come back under the spotlight. Although global economic prospects may have improved, they are a long way from perfect. As a result, it is difficult to see industrial cyclicals delivering anything other than mediocre earnings growth going forward.
As Mr Batty puts it: "The problem is the low interest rate, low inflation environment is likely to continue. The pricing power of cyclicals will be constrained and that will affect earnings. Investors will still be willing to apply a premium rating to stocks that can offer premium earnings growth.".
Abby Cohen, chief strategist at Goldman Sachs, agrees. "Downward stock price pressure in several areas, for example growth stocks and mainline technology, is not warranted. Much of this pressure presumes a vigorous global economy, heightened inflation and notable rises in interest rates that we consider unlikely," she says.
This all suggests ICI et al should enjoy the attention while it lasts. Unless global inflation becomes a real concern, the rush for cyclicals could be short-lived. Indeed, yesterday's bout of profit-taking in the sector suggests the City could have already begun to tire of the stocks.
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