Near-Term Slowing Is Scaring Industrial Sector Investors

by: Alan Brochstein, CFA

Earnings season has been particularly tough on the industrial sector. The S&P 500 lost 2.15% in July, while the industrial sector was slammed by 7%, wiping out all the gains so far this year. Earlier in the year, it had been jockeying for first place among the 10 sectors, but now it is middle of the pack and lagging the market (click to enlarge images):

Industrials have been doing well for a while - here's an easy way to see. The chart below is the SPDR Industrial (NYSEARCA:XLI), and the blue line represents the relative strength against the S&P 500:

Over the past twelve months, industrials have now lagged the overall market by about 2%. Looking at a longer perspective, though, they retain leadership over the past five years that was interrupted by the collapse in 2008-2009.

The bull case for the sector has been the growth outside the U.S. and the need for emerging economies to invest in tools to build out their infrastructure. Now, with concerns cropping up regarding the outlook for growth in the BRICs and beyond, it's not surprising to see investors questioning their assumptions.

The tone of earnings calls this week was not as strong as it has been in prior quarters, encouraging profit-taking as outlooks were reduced modestly. Take a look at the damage just over the past week, with the following members of the sector losing 10% or more:

  • CH Robinson Worldwide (NASDAQ:CHRW): -10%
  • Emerson Electric (NYSE:EMR): -11%
  • Flowserve (NYSE:FLS): -11%
  • Illinois Tool Works (NYSE:ITW): -13%
  • Paccar (NASDAQ:PCAR): -15%
  • Rockwell Automation (NYSE:ROK): -14%
  • Stericycle (NASDAQ:SRCL): -11%
  • Waste Management (NYSE:WM): -13%

That's 8 stocks that plunged during the week. By the way, 26 S&P 500 stocks in total fell 10% or more last week.

Here is an example of the type of commentary that triggered the sell-offs:

Our second quarter revenues finished slightly lower than our original forecast, as we experienced some modest slowing in industrial markets.

For the full year 2011, our forecasted EPS range for continuing operations is now $4.05 to $4.21, based on a total revenue increase of 16% to 18%. The midpoint of $4.13 would be 43% higher than 2010. This full year range compares to our previous forecast range of $4.08 to $4.26.

The company in question? ITW, which is considered a great bellwether for the sector. That's a pretty nasty reaction for a modest reduction in the outlook (1% at the mid-point).

At any rate, there is no doubt that near-term slowing is scaring investors. Three months ago, when I launched my Sector Selector ETF Model Portfolio, I purposefully avoided large-cap industrials and focused instead on emerging market equities and U.S. technology companies, as I thought that they were a more affordable way to play the same basic trends of stronger growth outside the U.S. In fact, technology companies are not only still cheaper, but they also have far superior balance sheets. With that said, I sense that the demand for I.T. is a lot less than some of the unique types of tools and equipment made in the U.S.A.

I have reacted to the sharp decline in XLI by adding an initial 5% position to the model portfolio, funding it with sales of a consumer discretionary ETF and an ETF dedicated to mega-caps. I continue to find smaller industrials to offer even greater value, but, with the underperformance among the large-caps, I am willing to stick my toe in the water now.

Disclosure: I am long XLI in a model portfolio at Invest By Model