Orders for durable goods are due out on Thursday before the opening bell and investors could be in for a continuation of this week's downward slide. The market is expecting a rebound of 6.0% in orders after the August report shocked investors with a 13.2% drop against three straight months of gains. Orders for non-defense capital goods, excluding aircraft managed to increase 1.1% in the month but only after a sharp 5.2% decline in July. The decline in the proxy for business investment is leading many to fear a reduction through the last half of the year as businesses choose a wait-and-see approach to fiscal uncertainty.
Particular weakness was seen last month in new orders for non-defense aircraft, down 101.8%, and a 40.1% drop in orders for goods related to defense. Even removing the more volatile segments of the report showed a weakening trend for most capital goods and business equipment investment. With consumers still fighting high unemployment and flat real wage growth and the government facing fiscal contraction, the economy cannot withstand a hit to business investment as well. Further weakness in Thursday's report could send markets down sharply. Investors may want to position in quality names with compelling valuations.
Recent sell-off still has room to run
Markets will most likely rebound on Wednesday after the S&P500's drop of 1.4% yesterday and more than 3.2% over the last week. While earnings have generally met lowered expectations, guidance has been weak and the markets are coming off their central bank-induced rally. Thursday's durable goods report will be more important than usual and another negative read after last month's disappointment could be the pin in the proverbial coffin for the market.
Alcoa (AA) narrowly managed to remain profitable when it reported a net gain of $0.03 per share in the third quarter, not including the negative impact of special items. The company saw total sales plunge 47% to $5.8 billion from the same period last year even as the cost of revenue remained high at $5.3 billion. Even after backing out the affects of extraordinary items on earnings, the company trades for more than 54 times trailing earnings. Going forward, the company faces several significant challenges. General weakness in global growth will act as a headwind to aluminum prices. Further, the frenzied pace of auto sales through the first half of the year may weaken on a continued high unemployment rate and fiscal uncertainties. The durable goods report is especially relevant for the company and any negative surprise could send the shares down further than the general market.
Shares of the 3M Company (MMM) lost more than 4% on Tuesday when the company cut its full-year earnings forecast against continued weakness in Europe and Asia. Management cut guidance almost two percent to a range of between $6.27 to $6.35 per share. Sales for the third quarter declined by 0.5% to $7.5 billion while the company managed to meet expectations for a net gain of $1.65 per share. The company is a global manufacturer operating in a range of sectors including: industrial & transportation (33% of revenues), healthcare (17%), display & graphics (12%), consumer office (14%), electronics & communications (11%) and security (13%).
Though sluggish, economic growth in the United States has been one of the few bright spots for the company. Weakness in orders for durable goods could turn this negative as well and hit the shares particularly hard after a negative earnings report.
High quality names to ride out the storm
Johnson Controls (JCI) recently reported that it would take a pre-tax charge of between $225 million and $275 million in the fourth quarter on restructuring and pension costs. The company is expected to report a net gain of $0.75 per share on October 30th, flat over the same period last year, on a slight uptick in revenue. Johnson Controls has been able to grow revenue by a compound annual rate of 6.7% over the last decade and has reduced its long-term debt-capital ratio to around 30%. The stock trades for a relatively cheap 10.5 times trailing earnings and pays a 2.7% dividend yield. Weakening auto sales and a sluggish global economy make act as a headwind on the shares but the company is addressing key structural issues and is attractively priced.
Boeing (BA) is the world's second largest maker of commercial jets and the third largest military weapons maker. The commercial segment accounts for 49% of revenues, while military funding makes up 50% of revenues. Though the economy is not exactly driving commercial sales, the obvious weakness here is in revenue from military spending. Next year's proposed cuts to defense are still on the table though I believe Congress will reach an eleventh-hour accord to defer the bulk of the cuts. The company recently announced a 20% increase in its production rate for its 777 jets. This drive for efficiency and a backlog of 335 planes should help to moderate any effects of a slowdown in defense spending. The shares are priced relatively cheaply at 12.8 times trailing earnings and pay a 2.4% dividend.
United Technologies (UTX) reported strong third-quarter earnings on Tuesday with an adjusted profit of $1.37 per share against expectations for $1.19 per share. Management has had the foresight to divest weaker segments like rocket engines, wind turbines and industrial pumps to grow total sales by 5.7% over the same period last year. The company's operating margin of 14.3% is above 86% of its peers in the Aerospace & Defense industry. Trading at 13.2 times trailing earnings, the shares may not be as attractively priced as Boeing but the company is well-run and pays a 2.7% dividend yield. While a weak durable goods report will weigh on the shares, management has proven itself capable of handling the external environment to beat expectations.
A tale of two markets
The last week has caught the market between opposing economic forces. On the one hand, Europe may finally have a credible backstop to its crisis and global central banks seem committed to supporting asset prices through unlimited easing. The other hand holds increasingly weak forward guidance out of earnings season and the world's largest economy almost definitely facing significant fiscal contraction in the coming year. Last month's print of durable goods was a big downside surprise and this month is expected to bounce back marginally. Any unexpected weakness will confirm the market's fear of fiscal cliff-induced weakness in business spending and could set the tone for the rest of the year. Investors may want to seek shelter in quality names like Johnson Controls, Boeing and United Technologies against more cyclical names like Alcoa and 3M.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.