Monday's ISM Manufacturing Report was an eye opener and a call to action as well. The Report that Shook the World indicated that the manufacturing sector was in contraction, a fact not one economist foresaw. The data pointed to export softness as the key source of trouble, with both Europe and China indicating slowing demand for goods.
The entire industrial complex was sharply lower Monday as a result, with the Industrial Select Sector SPDR (XLI) ending down 0.9% on the day; that compared to a fractional drop for the SPDR Dow Jones Industrial Average (DIA). The most significant stock components of the XLI exaggerated its decline, with General Electric (GE) down 1.7%, Caterpillar (CAT) cut 1.5%, Emerson Electric (EMR) sunk 2.5% and Honeywell (HON) off 1.2%. I do not view this as a buying opportunity though, and would advise investors to take heed of this deafening alarm that manufacturing wanes and economic contraction may loom.
It's not coincidental that each of these four companies has a relatively high beta coefficient. I recently authored an article on GE entitled General Electric Shares Face Cyclical Risk, within which I noted the company's historical record of exaggerating the movement of the broader market. It's that cyclical risk, and this group's direct sensitivity to the U.S. domestic economy and international economies, that has me taking a critical look at these names today.
Security Name & Symbol
Industrial Select Sector SPDR
Obviously, the market risk of the XLI is mitigated a bit by the diversified pool of securities within it. It is still notable that its beta is a tenth of a point higher than 1.0. The 3-year beta coefficient of the Consumer Discretionary Select Sector SPDR (XLY), one that you might expect to reflect sensitivity to market volatility, is only 0.9.
What about valuation you ask? It's always a good question to ask. Whether you are a bottom-up or top-down investor, you should ask that question as it can help you make the best portfolio allocation decision. For those of you who must hold some stocks within a given sector, you are going to have to ask that question. You have to take a closer look at each individual company's situation to determine if a discount or premium is warranted and whether it affects your decision on a particular stock's inclusion or removal.
Basic Valuation Metrics of the Group
Historical P/E-5 Yr. Ave
Obviously, dividend yield plays a role in the investment decision here, and will make these shares generally more appealing than high-beta stocks that do not pay a dividend. These larger companies also have some downside protection against more speculative high-beta names because of their sheer size.
GE and HON would seem candidates for sale based on their premium to historical P/E ratios, but questions must be asked regarding the companies' current mix of operations. Are there special situations that support the premium? For instance, does HON's Defense Sector participation play a special role for or against it? I would argue for, because of my general view that a war in the Middle East will remind budget minders of the necessity of defense spending. This view would not stop me from selling the shares though, as I believe the market does not share my view. Others might argue that defense spending should and will be cut due to budget needs. Another question we might ask is whether Caterpillar's P/E discount compensates for its high beta, and if its agricultural component might help mitigate some of its industrial risk.
Clearly, these are not automatic decisions, given company specific information, but your high-beta cyclicals should definitely be under review today to limit your downside risk.