A stronger economy usually bodes well for cyclical stocks, so why are some analysts telling investors to steer clear?
Cyclical companies, whose profits rise and fall along with the economy, have done very well this year -- perhaps too well, according to some analysts. Although the economy is on track to grow around 4% in the third quarter, some experts believe cyclical stocks have already priced in the good news and that valuations are starting to look stretched.
"Our enthusiasm for cyclical recovery beneficiaries has cooled," said Banc of America analyst Tom McManus. "Now is the time for the laggard groups to play catch-up."
The Morgan Stanley cyclical index has risen 27% this year and is up 7% in the last month alone as economists have begun to ratchet up their growth forecasts. Last week, Merrill Lynch, Goldman Sachs and J.P. Morgan all raised their economic estimates for the second half of the year. Yet earnings from the cyclical sector don't look particularly impressive.
According to First Call, consumer discretionary firms, which include automakers and retailers among others, are expected to grow profits by just 2% in the third quarter. And the capital-goods sector isn't expected to post any growth at all. In comparison, the
is expected to grow earnings by almost 15% this quarter, 11.4% if
The run-up in stocks and stagnant earnings growth in the current quarter has left both consumer cyclicals and basic materials trading at higher price-to-earnings ratios than the overall market, according to Thomson First Call. In recent weeks, analysts have cut their ratings on
and reduced weightings in consumer discretionary names like
, citing their lofty valuations.
Brett Gallagher, head of U.S. equities at Julius Baer Investment Management, said he has been shying away from consumer cyclical stocks for some time.
"The cyclicals are pricing in a pretty healthy turn in terms of the economy and earnings," he said. "The market has been behaving as if this is a normal cyclical recovery, but the downturn wasn't typical. Consumers continued to spend throughout and therefore there's no pent-up demand to be released."
Gallagher said he is still hanging on to some basic-materials stocks because he believes the dollar will resume its downward trend, which should benefit these firms. "But I will acknowledge they're pretty fully priced," he said.
Charlie Crane, portfolio manager at Victory SBSF Capital Management, has been reducing his exposure to the consumer discretionary group all year, and while he still maintains positions in industrial stocks, he admits that valuations are a concern. "We are closer to selling our cyclical holdings than we are to buying," he said.
The consumer cyclical and industrials sectors are trading at 25 times and 22 times this year's earnings, respectively, according to First Call. The S&P 500, meanwhile, trades for about 19 times earnings.
Although cyclical stocks often provide attractive returns over short periods -- usually at the start of a new bull market -- their intermediate and long-term record is disappointing, according to McManus. "The best time to buy is when the outlook is bleak and dividend yields are high," he said. "Now that their yields have fallen, the risk/reward tradeoff is less compelling than a year ago."
Portfolio managers have snapped up cyclical stocks this year at the expense of more defensive names, which are more heavily weighted in the S&P 500. As the end of the year approaches, however, some analysts say fund managers will take profits and move their portfolios in line with the S&P by buying stable growth companies with lower P/Es.
Not all analysts are so pessimistic about the sector, of course. Smith Barney analyst Tobias Levkovich said cyclicals can continue to outperform, at least through the end of the year. Indeed, he raised his rating on the capital goods group Monday, noting that commodity prices have been rising and that order trends have been getting better.
Still, many analysts believe the best gains have already been seen. Seth Scholar, senior research analyst at Sand Hill Advisors, said while cyclical stocks -- including some of those from the tech sector -- should benefit from an economic recovery, there's no guarantee that the economy won't weaken again in the future. Meanwhile, these stocks are simply too expensive. "With some of these stocks," he said, "you have to go as far as 2005 earnings to get a decent multiple."