The New Safe Haven: Industrial Cyclicals

Includes: BA, CMI, DE
by: The Independent Investor

So the market rally continues despite the high level of negativity that surrounds the current investing and trading environment. As a wealth manager and trader, I think it is interesting to see how well the market continues to hold up despite continued bad news out of Europe, weakening economic data in Asia, and decent but not great news in the U.S. As I wrote from a short-term trading perspective in my last article, the most recent economic data continues to suggest that European credit woes are beginning to increasingly creep into the European economies and those like China that are highly levered to the weakest parts of these credit constrained economies.

In this kind of environment, it is easy, perhaps too easy, to simply throw in the towel on investing. While some individuals and institutions have already gone to cash and bonds almost exclusively, others continue to allocate capital almost exclusively to the traditionally highly defensive sectors like tobacco and health care, and still others attribute the recent rally to seasonal window dressing. Despite this continued negativity, mixed economic data, and high levels of trader and investor pessimism, the strongest performing parts of the market have consistently been traditionally riskier sectors like the industrials.

Stocks and other assets frequently go up for many reasons, some logical and some not, so it is worth asking why these traditionally cyclical stocks are likely performing so well of late. While explanations for the reason why the risk trade has outperformed over the last couple months range from progress in Europe to recent easing by central banks in emerging markets like China, a simpler answer might be the correct one. Maybe it is just risk versus reward.

When you look at the ten year yielding still just around just 2% and most defensive stocks in the tobacco and health care sector at 52 week highs, with some at historic highs, it is worth asking what the potential upside in these sectors is really likely to be from here. Now that Europe appears at least willing to avoid imploding while the U.S. and the globe appear unlikely to reenter a recession, industrial stocks don't seem quite as risky anymore. These companies generally have pricing power and tend to perform the best in a growth or inflationary environment. Also, in addition to most yielding at or near what most bonds will offer, these stocks are also significantly below their highs of just a couple years ago.

If you look at traditional safe heaven asset classes like defensive stocks and bonds, they are almost all at or near historic highs. Meanwhile, if interest rates move higher or inflation from central bank actions begins to pick up, the investing landscape could change both significantly and very quickly. If inflation or growth even begin to show signs picking up from the extremely tepid levels we have seen over the last year or so, capital will likely move fast and far from traditional safe heavens that are already significant if not overly invested in asset classes by many portfolio managers.

With signs of a depression diminishing each month now that Europe is starting to take more aggressive action, holding industrials and waiting for a big upside move is also far less risky that it was even several months ago. The fact that many traditionally strong blue chip industrials like Deere (NYSE:DE), Boeing (NYSE:BA), and even smaller companies like Cummins (NYSE:CMI), had very strong earnings reports and fairly solid guidance is yet another reason why holding these stocks is not as risky as some would have you believe.

To conclude, whether or not you believe that the economies are getting better, or that coordinated central bank or other government action will reignite growth around the world, it is becoming increasingly clear political leaders and central bankers are no longer willing to stand by as their economies continue to weaken. The fact that the Tea Party led House of Representatives is even willing to work with Obama in an election season on certain key issues, is a very strong sign of this new trend.

With many central banks and governments now actively pursuing policies of monetary easing and fiscal stimulus, it is worth asking if the investor paradigm of risk has changed. Strong growth may be years away, but if inflation returns or interest rates begin to move up, it will likely cause a lot of pain for companies without pricing power and assets that offer a fairly fixed return. While it is always easiest to see the future through the eyes of the immediate past, sometimes things change, and when they do, they change quickly.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.