Cramer's Rewrite of His 'Examining Cyclicals' Piece

The trader explains the only way to make money on these stocks.
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Cyclicals -- boy, am I sick of that impenetrable term. Can we take a moment, Ally McBeal-like, to figure out what the heck they are before the talking heads confuse us any more on the subject?

(First of all, when I first walked in the door at

Goldman Sachs

, it was 1982, and I didn't know a cyclical from a conical. The idea that there was a whole group of stocks out there that did well only when the economy did well seemed like a stupid idea. Who would want stocks that depended on an economy as crummy as the United States' to make money? Little did I know that at that moment the great peacetime expansion was starting and cyclicals would be a dynamite place to be, off and on, for many years, until 1990.)

First, as Lou Rukeyser used to say -- or still may be saying, for that matter -- let's speak English.

(Cheap shot, but I would rather watch Ally McBeal that Sweet Lou anyway.)

Cyclical companies are companies that need a strong worldwide economy to report up earnings. Forget about them. They are unimportant. We are not concerned with the corporate entities.

(I am being glib here. Obviously companies do matter. It is just that every newspaper and magazine in the world covers the companies. Only we cover the stocks. That's what I care about. That's what this piece is about. Cyclical companies do well when the economy is firing on all cylinders. Cyclical stocks can do terribly then, if inflation is rampant. So let's not confuse the issue. I'll let the Wall Street Journal's Pittsburgh, Cleveland or Detroit bureaus handle the companies, I will take care of the stocks.)

Cyclical stocks, on the other hand, are what matter to us. This is

TheStreet.com

, not some economist tome or a daily newspaper. Cyclical stocks are entities that go up when: (a) They get takeover bids from other cyclicals; (b) Fidelity decides that the drug stocks are too pricey; (c) polyethylene and other "-lene" price increases stick for more than four weeks; (d) container-board price increases ever stick; and (e) some giant hedge fund buys calls on the

Morgan Stanley

cyclical index, or CYC, sending the underlying stocks up. All these things are happening right now.

(Here is the meat of this whole piece and I am going to spend a ton of time on each point. Trying to figure out what makes these stocks go up will allow us to gauge the longevity of the move.)

(A. Cyclical companies love to take over other companies. First of all, they can immediately combine head offices, manufacturing, servicing and all of that overhead. Second, cyclical stocks love it when companies close down capacity or take it out, and they hate it when capacity is added.)

(Mergers mean that the worst, most inefficient plants get closed, capacity gets taken out and prices increase for the commodities the cyclical makes, regardless of demand. Let's take this

International Paper

-

Union Camp

(UCC) - Get Report merger. It is incredibly bullish for that industry and for IP and you can expect that if this move continues, IP will have a lot of mileage ahead of it. Similarly,

Alcoa

(AA) - Get Report has made many consolidation moves in the past few years and it has benefited immensely. Remember: capacity out = good; capacity added = bad. Simple, never forget it.)

(B. Fidelity is the broad rubric I use for mutual funds that sell sectors, not just stocks. Think about it, at various times whole sectors get overvalued. In the 1980s I saw the oil and oil-service sectors get too overvalued, then the food sector got too overvalued, then the construction sector, the tobacco and soda sector, then the health care sector and finally the tech and the Internet sectors. Too much supply, too many stocks, too much of a representation in the

S&P

.)

(Right now, going into this year, the cyclicals represented the smallest percentage of the S&P that I can recall. There simply were very few of them that survived either through the '90s. There were so many takeovers and then so many worldwide crises, that many of these companies could not survive independently.)

(Coming into this year both the pharmaceutical and tech sectors, in retrospect, got too overvalued vs. the cyclicals, given that the worldwide economies were in recovery mode. Mutual funds love upside surprises, real upside surprises, not manufactured ones, done by buybacks and aggressive accounting. We started to see those surprises pop up in the cyclicals this past quarter. That lead to a sea change, out of the overvalued into the undervalued and it continues.)

(C. When you think of the building blocks of the economy, think plastic. Plastic pricing is incredibly important as a barometer of worldwide demand. There are lots of different grades and kinds of plastic. They tend to have the same oil-based (-ene) roots. The pricing of these commodities is incredibly important.)

(That's because these firms tend to have fixed costs. If they ever "get" any pricing, meaning they can raise prices, either because demand has picked up or capacity has been taken out, they can report some unbelievable numbers. There is finally some pricing in plastic, I think because of the Asian and Latin recoveries.

Dow Chemical

(DOW) - Get Report, a big plastics company, and

DuPont

(DD) - Get Report, a plastics and life sciences company, have both seen some pickup in demand and pricing of some grades of plastic. That was the sign to many people to get on board.)

(D. Linerboard is another sensitive indicator of the economy. Linerboard pricing and container pricing in general is very leveraged to worldwide growth. There used to be hundreds of little linerboard companies but many of them have vanished because this downturn has been totally brutal. True cyclicals are companies that make commodities that are interchangeable. Linerboard is the ultimate commodity like steel as it is made everywhere -- here, Canada, Sweden -- and is constantly being priced and repriced monthly.)

(As the cyclicals come back in vogue, you will be hearing more and more about price increases and potential price increases in linerboard. These increases will make these stocks jump every time. Watch for them.)

(E. Earlier in the decade Morgan Stanley crafted a consumer index and a cyclical index. These were baskets designed to mirror the two groups. The consumer index is really kind of a broader version of

Warren Buffett's

portfolio. The cyclical index, however, is made up of plastics, wood, paper, steel, chemical semiconductor and financial (Citi) concerns. It trades wildly and erratically. It hasn't really done anything for years and the stocks that underlie it have almost, to a company, shrunk their floats by using their excess cash flows to buy in stock.)

(None of these companies has really expanded capacity in the last decade. The last two years have seen nothing but declines in many of these stocks because of the Asian and Latin crises. But during these crises many of these companies improved their efficiencies and rationalized their capacities. They brought in tech. They cut costs. They stopped hiring. And when they had nothing else to do with their cash, they bought back stock. Billions of dollars of stock. Now that stock is gone, crunched. So when some account comes in to buy cyclical index calls, he can move the underlying stocks radically. I believe if I had come in with $5 million worth of deep in-the-money calls to buy in this index Friday when it was down 10, I could have moved it back to unchanged. These stocks are thin, thin, thin with no supply.)

(Importantly, when we speak of cyclicals, don't confuse the issue. These are companies that need the economy to do well. Someone this week asked me why

GE

(GE) - Get Report wasn't going up. That company has done everything it can to REDUCE its cyclicality. It could fall radically out of fashion in this environment.

Boeing

(BA) - Get Report, however, a poorly run company that needs aircraft orders, could do extraordinarily well in this period. Alcoa is a well-run company that has the possibility for an earnings explosion if things go right, which is why it went up 20 points this month.)

That's it. That paragraph is all you really need to know. Cyclical stocks have to be bought when business stinks and their price-to-earnings multiples are gigantically high, almost Net-like. They have to be sold when their P/Es are in the low single digits.

(If you take away one thing from this piece, it should be that the stocks precede any sort of upturn. You cannot wait until ingot pricing changes to the upside to buy Alcoa. These stocks are forecasting a rise. This is not like owning

Pfizer

(PFE) - Get Report. You have to get in well ahead of the good news when earnings are still bad and nobody likes these stocks. Only then can you make the big money. That's why I was buying oil-service, plastic and chemical companies on Friday into the downturn. These companies are going to experience price increases if the economies of the world get strong, and there will be electrifying moves in these stocks.)

Don't believe me? The greatest cyclical short of my lifetime was

Bethlehem Steel

(BS)

when it had a P/E of around 2 on forward earnings because those earnings never materialized. As prices move up for commodities, more capacity comes on line; as more capacity comes on line, prices come down; as prices come down, earnings are missed. Then foreigners dump stuff here and really destroy earnings. The multiple expands, horribly, to absurd levels. Analysts reiterate buy ratings all the way down, and they bury you as the stocks get killed.

(This actually happened about four times in the last 20 years and is happening again, which is why I hate the steels and won't play them.)

You lose money.

(The endgame of the cyclicals is that you must sell them at their peak when their multiples are lowest and the stocks are at their fattest. This is an incredibly difficult concept and I will be there helping you to understand it. When everything is going great, you want to get out. That's when the analysts will be going nuts for it, because it will look cheap. Right now these stocks look expensive, that's when you have to strike. The analysts are on hold right now for many of these stocks. You will put them on now and they will take you out at the top. I promise you that. I promise you it will happen just like that, because it always does.)

There are periodic rotations into cyclicals when economies are on the upswing. Because of turns in Brazil and Southeast Asia, we are in one now.

Can it be played? You have to trade these. You have to be incredibly nimble. You can't just own them. When the CYC makes a huge jump, you have to sell, and when it declines big, you have to buy.

(This is the same thing again as getting out at the top.)

You can do this as long as we are not in an earnings warning period when cyclicals fail to meet the numbers. We are not in that period, so it works right now, although 10 days ago I put a short on in this index and made a decent amount when money rotated out of the cyclicals and back into tech last week.

(You saw this in

Deere

(DE) - Get Report on Friday when it preannounced because the farm economy is not that strong. But in an harbinger of strength, this stock opened at the low and traded higher all day, finishing at the top. This stock wants to go higher. This group wants to go higher. People know this is the trough. You buy trough and sell peak. I can't emphasize that enough; when you trade cyclicals you buy trough and sell peak.)

(You buy____ and sell ____? Good work. Well done.)

James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund had no positions in the stocks mentioned, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

letters@thestreet.com.