Is The Rally In Industrials Predicting A New Bull Market?

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Includes: CAT, DHR, GE, HON, LMT, MMM, SPY, UNP, UPS, UTX, XLI
by: Daryl Montgomery

Summary

Traditionally, a rallying Industrial sector is usually a bullish indication for the stock market.

Industrials were the third-best-performing sector among U.S. stocks in Q1 2016.

The rally was given credence by moves up in energy and materials.

The picture is definitely bullish, but not necessarily for U.S. or Western European markets.

Bull and Bear markets are led by different stock sectors. Decades ago, when the U.S. economy was dominated by manufacturing, a rally in the Industrial sector after stocks had been down for a while would almost certainly indicate a new bullish trend in the market. The industrial sector not only includes the production of machinery used by a wide-range of industries and agriculture, but also transportation companies. The companies that belong to it require basic materials and energy, implying that these two sectors should be strong also. If it were 1956, the bull view for an improving stock market would be solid for the U.S. and Western Europe.

However, things have changed over the years, at least in the advanced economies. Manufacturing had a severe decline in the U.S. in the 1970s and has become increasingly less important to the economy since then. The 1980s and 90s saw the rise of the Technology sector, which led to the tech bubble collapse in 2000. Thanks to central banks and their easy money policies, the FIRE (Finance, Insurance, Real Estate) economy, then rose to prominence after that. While this is the case in the West, in China, the structure of the economy is much closer to what it was in the U.S. in 1956. It's also China that drives the global manufacturing economy today.

Industrials were only the third best performing U.S. stock sector in the first quarter,and the two best performing sectors, Utilities and Consumer Staples, are leaders in Bear markets. So, there is not too much to support a bullish stock market view on that piece of information alone. Market technicians seem very excited about the sector, however. At the "Legends in Technical Analysis" talk on April 6th, one of the speakers singled out industrials for out performance and another one's best stock idea was General Electric (NYSE:GE), the largest market cap stock in the sector. But, have there also been rallies in the materials and energy to confirm the move up in industrials? Well, yes, there have been.

Energy stocks were the worst performing sector in Q4 2015 and the only one with a negative return. By Q1 2016, they had moved up to 6th place. Oil, the commodity, had a very impressive rally from its bottom in January until the end of the quarter. By early March, steel, a major component of the Materials sector was up over 40% within a month. Iron ore, the only major component of steel, had a one day rally where it was up 19% (one of the biggest rallies for a commodity ever). This supporting evidence certainly adds credence that the move up in industrials has some significance.

The counter argument is that the rally in industrials seemed better than other sectors during early 2016 because it began earlier. Although the S&P 500 (NYSEARCA:SPY) bottomed in mid-February, the Industrial sector (NYSEARCA:XLI) bottomed approximately three weeks earlier. Some of the largest market cap components of the sector - 3M (NYSE:MMM), Honeywell (NYSE:HON), United Parcel Service (NYSE:UPS), Union Pacific (NYSE:UNP), and Caterpillar (NYSE:CAT) - had distinct bottoms in January. Others, such as United Technologies (NYSE:UTX), Lockheed Martin (NYSE:LMT) and Danaher (NYSE:DHR), made double bottoms in January and February. So, industrial stocks had less time to fall and a longer time to rally than stocks in other sectors. In the chart below, the bottom on the industrials is circled in red and the one on the S&P 500 in green.

Industrial Sector Versus S&P 500 Performance

While the earlier rally needs to be considered, the industrial sector is doing better regardless, but this should not be construed to indicate that a new bull market has begun for stocks - in the U.S. or Western Europe that is. Industrials, materials and commodities no longer dominate these economies, but they do have this role in emerging markets. Emerging markets did indeed have the best performing stocks globally in Q1 2016, especially in South America and Eastern Europe. They were, in fact, looking quite bullish.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.