A funny thing happened on the way to the end of the first quarter on Friday, March 30.
After leading the stock market for most of the quarter, cyclical stocks started to lag the Standard & Poor’s 500 Stock Index.
Is this a sign of what we can expect in the second quarter as worries about economic growth take the steam out of profits linked to the economic cycle? I’d say, Yes. I think we’re seeing the first signs that the pendulum, which swung to optimism and drove this rally, is swinging in the other direction.
Let’s start with some numbers. On the performance data there’s not much doubt that cyclical stocks, companies that recover when the economy does and that falter when the economy stumbles, started to fade in the last month of the quarter.
The S&P 500 returned 12.6% for the quarter and 3.29% for the month that ended on March 30.
But in the very cyclical auto sector—What rises and falls with the economic cycle more than car sales?—General Motors (GM) was up 26.54% for the quarter but down 1.42% for the month. Ford Motor (F) didn’t dip into negative territory in the last month of the quarter but the shares followed a similar pattern, up 16.4% for the quarter but up just 0.77% in the last month. An auto supplier such as BorgWarner Automotive (BWA) gained 32.32% for the quarter but lagged the S&P 500 in the last month with a 1.81% gain.
And it wasn’t just auto stocks where this trend played out.
Steel-maker Nucor (NUE) was up 9.46% for the first quarter but down 0.49% for the last month of the period. (The steel sector as a whole was up 9.12% for the quarter but down 4.55% in the last month.) Construction and mining equipment producer Caterpillar (CAT) was up 18.08% for the quarter but down 6.73% for the month. Diesel engine maker Cummins was up 36.83% for the quarter but down 0.44% in the last month. Titan International (TWI), which makes tires for construction, mining, and farm equipment, was up 21.56% for the quarter, but down 4% for the month.
I think you get the idea. The Morgan Stanley Cyclical Index (CYC) was up 15.8% from December 30, 2011 though the close on February 29, 2012. But from February 29 through the end of the quarter on March 30, the index managed just a 0.45% gain against the 3.29% gain by the S&P 500. (Membership in the Morgan Stanley Cyclical Index includes Alcoa (AA), Caterpillar (CAT), Johnson Controls (JCI), and US Steel (X).)
Why the stumble in what had been a great quarter for cyclical stocks? Because cyclical stocks are by definition those stocks most sensitive to the ups and downs of the economy. They’re the most susceptible to worries that the economy is about to slow. And the end of the quarter saw the return of those worries by the bushel.
The EuroZone looks headed for a deeper recession than originally forecast in the first half of the year. High oil prices have raised fears that the U.S. economy will slow. Manufacturing and export numbers show that China’s economy is slowing and corporate profits in China look like they’re moving lower.
So there’s no wonder that cyclicals have had a rough time in March. Add in profit-taking after the gains recorded by some of these stocks in the first two-thirds of the quarter and worries about earnings growth in the reporting season that starts with Alcoa’s earnings release on Tuesday, April 10, after the New York markets close. Alcoa can stand as a representative of what investors fear that they’ll hear from cyclical stocks in the quarter: The Wall Street consensus is looking for Alcoa to report a loss of 3 cents a share for the quarter compared to earnings of 28 cents a share in the first quarter of 2011.
In general I don’t see much to tempt me into putting some money into cyclical stocks before earnings season and the macroeconomic news from Europe and China answers a few questions about growth.
In the United States we get the March jobs numbers on Friday, April 6. Right now economists are looking for the economy to have added 200,000 jobs in the month. That would be enough to keep the economy’s string of 200,000 or better months alive but it would still be a decline from the 227,000 added in February. Near the end of the month, on April 27, investors will get the initial read on first quarter GDP growth. The U.S. economy grew at a 3% annual rate in the fourth quarter of GDP, up from a 1.8% rate in the third quarter. The fear right now is that high oil prices and the impending recession in Europe will cut into that growth rate.
We simply don’t know.
Equally, I think we’ll have a better understanding of the macroeconomic picture in Europe and China by the end of the second quarter on June 30 than we do now. Rising interest rates in Spain took the yield on the 10-year government bond to 5.4% at the close on Friday, March 30. That’s still well below the 6.5%-plus level that signaled crisis at the beginning of the year, but it is significantly higher than the yield in early March of just below 5%. The problem for Spain and the EuroZone is that every investor who can do basic math knows that the expansion of the EuroZone rescue fund agreed on Friday isn’t enough to meet current commitments and rescue Spain if the country needs a Greek-style restructuring or even an Ireland-style bank rescue. Spain’s tough, tough budget for 2012 announced on Friday with 27 billion euros of additional spending cuts and tax increases won’t deliver the 5.3% of GDP budget deficit for 2012 that Spain has promised if Spain, along with the rest of the EuroZone, sinks into recession.
How do we know that? Two “secret” reports by officials in the European Union, leaked to news organizations after being distributed to the finance ministers on Friday, say so. Despite 1 trillion euros in loans from the European Central Bank to European banks, “contagion may …re-emerge at very short notice,” says one of the reports. The second report says very bluntly, “The euro crisis is not over.”
Some very big money has visibly started to react to that rather pessimistic scenario. Norway’s sovereign wealth fund, which owns a whopping 2% of all European stocks, has recommended a cut to its exposure to Europe to 40% in bonds (down from 60%) and to 40% in stocks (down from 50%.) The move has to be approved by the Norwegian government (probably in early summer) before the fund can lighten up its European positions in favor of increased investment in the United States and in emerging markets. (Given increased cash flows into the sovereign wealth fund from higher oil prices, fund managers say they will be able to rebalance the fund without significant selling of existing assets.)
If all this feels like a swing of the pendulum back toward the fear and pessimism that ruled the financial markets before the rally began in November, I think you’re absolutely right. I think we’re likely to see a replay of the move to safety that bid up the price of U.S. Treasuries (and sent yields down) earlier in 2011. It’s hard for me to see emerging markets stocks moving up significantly if investors are spooked by events in Europe. Part of the reason that cyclical stocks—along with commodities and commodity stocks—fell in the latter part of March—is because traders started to reverse the moves that had been so profitable earlier in the quarter. The Standard & Poor’s GSCI index of 24 raw materials fell 2.1% last week in part on a Goldman Sachs call cutting its recommendation on commodities over the next three months. Among commodity stocks, Freeport McMoRan Copper and Gold (FCX) fell 10.6% in March and diversified Australian miner BHP Billiton (BHP) fell 5.75% for the month.
All this makes me very reluctant to jump into beaten down cyclical and commodity stocks right now. Yes, for example, Joy Global (JOY) has taken a beating in the last month—losing 15.28%–but sentiment is still moving away from these sectors. The stock’s chart, which I think captures that sentiment very clearly, is truly ugly at the moment. The 50-day moving average seems headed to a cross below the 200-day moving average, which is usually a very bearish sign. In this case I think you’d be in danger of trying to catch the proverbial falling knife. I’m going to add Joy Global to my watch list http://jubakpicks.com/watch-list/ today, April 3, but I’m not calling Joy Global a buy in current market uncertainty.
Let me be clear—I’m not calling for a collapse in global or U.S. economic growth. I don’t think China is headed for a hard landing. And I think what we’re seeing is a swing of the sentiment pendulum rather than some big deterioration in fundamentals for company earnings. It’s a call to wait rather than buy because I think many cyclical and commodity stocks will be cheaper in a matter of weeks or months than they are now.
If you have a time horizon that looks past, say, June, what you would like to be planning is to buy not too far down the road in anticipation of the next swing in the pendulum back in the other direction. If the People’s Bank of China cuts interest rates to stimulate the Chinese economy in June or so, as I think it will, if Brazil can get its economy headed toward higher growth, as I think it will given the magnitude of interest rate cuts from the Banco Central do Brasil, if U.S. economic growth can show its resilience to high oil prices and a European recession, as I think it will, then l’d look for a swing back from excessive pessimism during the summer months.
Do I think that swing will indicate that all problems are solved and that the global economy and global stock markets are ready to boom? No, unfortunately. The big, and so far intractable, problems of sovereign and corporate debt remain and the global economy needs to achieve much more deleveraging that it has in order to repair the balance sheets damaged by the global financial crisis (and the efforts to fight that crisis.) So I’d expect another swing back from excessive optimism toward the pessimistic end of the scale late in 2012 or early in 2013.
But one swing of the pendulum at a time.
At the moment I’d say wait to buy (with the one exception of the fertilizer sector where the tight crop forecast on Friday from the U.S. Department of Agriculture is enough, I think, to let stocks in this sector move up even as the pendulum swings. My favorite here—and I’ll explain why I think that later today—is Potash of Saskatchewan (POT).)
A handful of cyclical and commodity stocks have shown superior relative strength (to the average stock in their sectors) in March. I would hold onto shares of Cummins (CMI) and Johnson Controls (JCI), for example, here because the stocks barely budged to the downside in March, falling just 0.44% and climbing 0.09%, respectively. I don’t think the fundamental cycle for either of these companies is yet at an end. (But be sure you believe that yourself and that you’re convinced that you want to hold these stocks. The last thing you want to do is hold through the pain and then sell if the pain is worse than what I’m now describing.) Other cyclicals that fit this description include Nucor (NUE), BorgWarner (BWA), and Deere (DE).
If we do get another swing of the pendulum, try to remember that as wrenching as 2011 felt at times, it didn’t mark the end of the world. That’s easier said than felt, I know. But I do believe, perhaps foolishly, that we can learn from past mistakes. (Even if that only leaves us free to make new ones.)
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Cummins, Deere, Freeport McMoRan Copper & Gold, Johnson Controls, Joy Global, and Titan International as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
No related posts.