Industrial Strength

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Includes: CAT, DHR, DOV, FAST, GE, GWW, HON, IR, ITW, MMM, PH, SPY, TXT, UTX, XLI
by: Eric Parnell, CFA

Summary

The industrial sector is the linchpin for the U.S. stock market.

As go industrials, so goes the S&P 500 Index.

The bold profits forecast for the sector is already under heavy fire.

Several key companies warrant close attention in the coming days.

A big part of the rosy earnings outlook for the broader stock market through the end of next year is riding on renewed strength in the industrial sector after an extended dormant stretch over the past few years. It is a bold forecast, and it is already under heavy fire thanks to some prominent industrial names having slashed their outlooks in recent days. If a few more big names end up guiding lower in the coming weeks, it will almost place the lofty earnings forecasts for the already richly valued stock market in the coming year almost certainly out of reach. Not only would this bode ill for cyclical stocks, but also the broader market in general in the coming quarters.

Joined At The Hip

Industrials are more closely related to broader market performance more than any of the other eleven major sectors. One has to look no further than the price performance of the S&P 500 Index (NYSEARCA:SPY) versus the industrial sector (NYSEARCA:XLI) since the outbreak of the financial crisis nearly a decade ago. Deviations in price performance have been minimal and short lived over this entire time horizon.

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Ambitious Forecast

Industrial sector earnings have been lackluster at best dating back to the end of the Fed's QE3 stimulus program roughly two years ago now. Overall, annual operating earnings per share for this market keystone sector have stagnated between $27 to $28. These results look worse when viewed on an as reported basis, as earnings for the most recently reported 2016 Q2 were effectively unchanged from levels first reached in 2013 Q4.

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But supposedly this is all set to change soon. Projections for industrial sector earnings growth are heady in 2017. Over the next two quarters, including the just completed 2016 Q3 and the currently underway 2016 Q4, industrial sector earnings are projected to marginally contract on a year-over-year basis by -0.47% and -0.54%, respectively. So the stagnation is set to continue through this reporting season as well as next in the early part of next year. But then the switch is apparently going to be flipped on industrial earnings, which are set to increase at an accelerating rate by as much as a +10% annualized rate by the fourth quarter of next year. I'm not sure whether it's the flattening growth in the U.S, the threat of another banking crisis in Europe, the ongoing stagnation in Japan, the slowing of industrial activity in China or the persistent challenges across emerging markets that is supposed to be driving this miraculous profit quickening, but such is the forecast upon which talking heads are taking to their television microphones when pontificating about the anticipated profit recovery in the coming year. Awesome.

A Tough Start

This ambitious forecast has already taken some notable dings at the start of third-quarter earnings season.

The first larger industrial company to report was Fastenal (NASDAQ:FAST) on October 11, and the company ended up whiffing with profit numbers that fell short of expectations. The stock has fallen sharply by nearly -10% in the days since.

A day earlier on October 10, Dover Corporation (NYSE:DOV) slashed its revenue and earnings estimates for the upcoming quarter, which sent the shares of the industrial conglomerate also reeling lower by roughly -10%.

And from the "nothing can be too weird in the post crisis period" category starting a day before that on October 9, Honeywell (NYSE:HON) issued what looked like a profit warning, only to have its CEO David Cote take to the airwaves to try and walk it back late last week. The market apparently is not completely buying it just yet, as the stock has only recovered a fraction of its initial -10% drop following the news.

The Predictably Falling Earnings Forecast

The bumpy start to third-quarter earnings season is already taking its toll on the forecast for rosy industrial sector earnings in the coming year. Already, the forecasts for industrial sector earnings in 2017 have fallen by as much as two-thirds of a percent. Investors should fully expect that these downward revisions to the forecast to continue in the coming weeks, potentially at a fairly aggressive rate.

Implications For The Broader Market

Profit forecasts for the industrial sector appear to be set too high. And recent warnings from names in the segment suggest that more downward revisions and downside surprises may lie ahead. Given that the sector is a linchpin for the broader market, such negativity from industrials in the coming weeks has the potential to place meaningful downside pressure on the broader market as measured by the S&P 500 Index.

Who's Up Next?

Beyond watching daily for additional downward revisions to earnings forecasts in the days ahead - after all, how can a company make sure that they "beat" earnings expectations if they don't aggressively guide down their earnings forecasts leading into their actual reporting date - it will be worthwhile to monitor the third-quarter earnings reports of some of the leading industrial giants in the coming days.

Some of the key names to watch in the days ahead include the following (all reporting times are before the market open unless otherwise noted):

W.W. Grainger (NYSE:GWW) - reporting this Tuesday

Illinois Tool Works (NYSE:ITW) - Wednesday

Danaher (NYSE:DHR) - Thursday

Dover Corporation - Thursday

Parker-Hannifin (NYSE:PH) - Thursday

Textron (NYSE:TXT) - Thursday

General Electric (NYSE:GE) - Friday

Honeywell - Friday

3M (NYSE:MMM) - next Tuesday

Caterpillar (NYSE:CAT) - next Tuesday

United Technologies (NYSE:UTX) - next Tuesday

Ingersoll-Rand (NYSE:IR) - next Wednesday

In short, we should get a better sense over the next two weeks about the sustainability of the currently lofty earnings forecast for the industrial sector in the year ahead. But if the initial profit warnings from the sector are any sign, investors should exercise caution in being overly optimistic heading into earnings for these leading names.

Bottom Line

A robust earnings recovery is currently projected for the S&P 500 Index. And the expected strength of the industrials sector is a key linchpin in this anticipated profit acceleration. Thus, a parade of earnings reports from the leading industrial giants over the next week or so will provide valuable insight into the actual achievability of these lofty expectations. If the recent track record of -10% drops to start the quarter is any guide, it may be best steer clear of leading industrial names at the moment until greater clarity is provided. For if we see further profit warnings or sector leaders falling short of expectations, it may bring with it an unpleasant chill not only for these leading industrial names but also for an already richly valued broader market.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

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.

Additional disclosure: I am long selected individual stocks. I also hold a meaningful allocation to cash at the present time.