What a month for cyclicals. While the S&P 500, and its tracking exchange traded fund, SPY (SPY), has rallied over 20% since the summer lows of last year, and market leaders such as Apple (AAPL) are up over 30% this year, the sell-off since April has been brutal.
Most of the major U.S. indexes such as the S&P 500 and Nasdaq have held up fairly well during the recent sell-off. Still, cyclical sectors such as energy, the industrials and the financials, have sold-off hard. Market leaders in cyclical sectors such as Exxon-Mobil (XOM), Caterpillar (CAT), GE (GE) and Citigroup (C), have been poor as well.
This is why I find the strong recent rally in most cyclical sectors so interesting. I wrote several weeks ago that cyclicals were likely to significantly outperform many leading dividend and consumer staples stocks. While all traders and investors have good calls and bad ones, and one month is obviously far too short of a timeframe to draw lasting conclusions, the consistent recent outperformance of cyclical stocks is notable.
Obviously, the recent news that Germany has recently ratified the new European Stability Mechanism framework, which was set up to recapitalize the European banking system, was important. Still, the market has now consistently rallied for most of the past month, and cyclicals such as GE continue to find strong support at around 9-10x average estimates of next years earnings.
Investing is simple if you know what stage of the business cycle the economy is in. You simply look up the past performance of cyclical stocks during periods of economic strength, and consumer staples during periods of economic weakness, and allocate capital accordingly. The problem is that the economy has experienced repeated periods of weakness during the last three years since the recession of 2008, and each time, the economy has not re-entered a recession. Cyclical stocks, such as GE and Caterpillar, have been strong buys on each pullback as well, and neither company has cut its dividend during the recent recovery period.
Obviously, predicting short-term and long-term economic cycles is difficult, or even impossible; the question for long-term investors is risk and reward. While the growth outlook in Europe and most emerging markets remains weak today, most leading industrials, such as GE and Caterpillar, continue to show strong growth across these companies' North American divisions, and strong growth in most of these companies' overall industrial divisions as well. Both companies recently raised dividend payouts by 13% as well.
What many traders and investors seem to be underestimating during each of the recent periods of economic weakness and subsequent market sell-offs, is the power of strong balance sheets and low rates. While cyclicals by definition perform best during periods of economic strength, companies with significant capital and limited investment opportunities continue to spend and borrow aggressively to cut costs and secure cheap capital.
Caterpillar's leasing business remains strong, as companies can borrow at artificially cheap rates and keep equipment they may or may not use short-term. Also, companies such as GE and Boeing continue to see strength in products and services offering significant cost savings, particularly in the energy space. Boeing's backlog for its new and more fuel-efficient dreamliner continues to be robust, and GE's energy and infrastructure businesses continue to grow in the high single digits.
With most leading cyclical stocks such as GE and Caterpillar are trading at 10-12x average estimates of next years likely earnings, and leading dividend stocks such as Altria (MO) and AT&T (T) are trading at 14-16x next years average earnings estimates, the risk-reward of being long industrials with strong and stable earnings as well as solid dividends is minimal. Strong balance sheets and cheap capital should keep corporate earnings strong, and if the economic recovery does accelerate, industrials should be strongly positioned as well. Most leading cyclical companies, such as GE and Caterpillar, also have raised these company's dividends at more robust rates than nearly every major consumer staples company over the last year.
To conclude, while it is always easy to try to see cause and effect between events and market movements, sometimes markets rise and fall because they are overbought or oversold. With interest rates likely to remain low, and capital at artificially cheap levels, many leading cyclicals will likely continue to have strong earnings as long as the economy does not re-enter a recession. With many cyclicals trading at 15-20% discounts to leading dividend and consumer staple names, cyclicals should continue to be a more appealing investment than dividend and income stocks.