Market Musical Chairs: 3 Stocks That Could Tumble And 2 Quality Names To Keep Going

Includes: CAT, DE, GE, MMM, XLI
by: Efficient Alpha

The S&P 500 was on track to post a second day of losses on Wednesday after spending most of the day about 0.4% down. Minutes from the last meeting of the Federal Open Market Committee that were more dovish than expected helped the broad index finish flat for the day on renewed hopes of more monetary stimulus.

Retail and housing numbers out since the previous meeting have generally been better than expected and have marginally lowered the probability of easing at the Fed's next meeting in September. This has slowed the market's run a bit and investors may want to hedge their portfolios for some profit-taking. Incrementally slower gains on low volumes lately strike me as something like a game of financial musical chairs. Investors have enjoyed an 11% run in the S&P 500 since June, but it feels like someone is about to turn off the music.

While weaker data may ultimately lead to more monetary stimulus, it could also be the catalyst for a breather in the market's three-month rebound. The durable goods report, due out before the bell on Friday, has been weak this year as businesses put off investing in capital expenditures in light of an uncertain economic and political environment. The consensus is for an increase of just 0.3% after two months of 1.6% month-over-month growth. Another negative print, especially if accompanied by a negative reading on core capital goods, could be the trigger that sends the market downward.

While the headline number rebounded over the last two months, investors were disappointed in June at weakness in core capital goods. The subcomponent excludes volatile defense and aircraft spending and represents business investment demand, a key component of gross domestic product. Orders for core capital goods shrank by 1.4% in June after rising 2.7% in May. Orders for aircraft have been strong and have accounted for much of the strength in the headline number. Excluding the volatile segment, spending on other durable goods also fell by 1.1% in June.

Other Reports Signal a Possible Disappointment in Durable Goods

Though last month's durable goods report came in below estimates, the weakness was not altogether a surprise. The ISM Manufacturing Index for July reported a second consecutive month of contraction in the sector and regional manufacturing surveys have previewed weakness in new orders. June's ISM report broke a 34-month expansionary trend in manufacturing. Still even more worrisome is that a closely followed survey of small businesses reported a second month of employment contraction in July as well.

As we move closer to next year's fiscal cliff and uncertainty around tax policies and public spending, data on capital spending and employment could start to weaken further as businesses choose to wait for a more certain environment.

Weak Report Could Hit Large Industrial Companies the Hardest

Despite its worldly scope, General Electric (GE) still receives 67% of revenues from within the United States and Europe. Continued weakness in the two markets could threaten top-line growth. Profits in its energy and transportation business helped to mitigate charges in the finance division in the second quarter. The company reported earnings of $0.29 per share and revenue of $36.5 billion, slightly under expectations for sales of $36.77 billion. The shares trade for a relatively expensive 14.6 times trailing earnings but pay a healthy 3.27% dividend yield.

The company has been increasing its exposure to the healthcare sector and now receives 13% of sales from a variety of medical imaging and diagnostic products. Yesterday, GE announced its second venture-capital funding project within the Israeli healthcare sector with an investment into the specialty monitoring firm Ornim Incorporated.

I prefer the 3M Company (MMM) on fundamentals and business diversification. 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%). The company has increased revenues by a compound annual rate of 6.1% over the last nine years, well above the 1.2% rate of growth at General Electric. The shares are a marginally more expensive at 15.1 times trailing earnings and pay a 2.55% dividend.

3M also missed revenue expectations in the second quarter, reporting a drop of 1.9% to $7.5 billion versus expectations for $7.79 billion. Despite economic uncertainties, the company maintained full year forecasts and projected organic sales growth of 2% to 5% for 2012.

Not All Heavy Machinery Stocks are Created Equally

The weak economic environment in the developed world and fiscal problems in the United States will most likely keep companies from devoting too much cash to capital expenditures like heavy machinery. The outlook for mining and construction equipment is marginally better than that of agricultural machinery.

I have been bearish on shares of Deere & Company (DE) since early July as poor weather patterns across the globe threaten cash flows for agricultural producers. While the company acknowledged some weakness in its quarterly earnings report, I think there is more trouble on the way for the $30 billion farm machinery manufacturer. An article earlier this week uncovered another potential problem that has not yet been discussed or priced into the shares. Farmers that pre-sold their crop in the futures market may be forced to buy back contracts if yields drop so low that production comes in below promised deliverables. Prices have increased significantly since spring planting and the scenario could affect producers' ability to repay debt or upgrade machinery. Deere trades for 10.2 times trailing earnings, slightly higher than others in the industry, though the dividend yield of 2.3% is higher than the average.

While Caterpillar (CAT) could also feel the pain of decreased spending on capital goods, the company's 2011 acquisition of Bucyrus International helped to increase exposure to higher growth markets in Asia and Latin America. The company sees approximately 70% of sales from markets outside of North America and is more heavily geared to construction and resource industries than Deere. Caterpillar has managed to grow revenues at a compound annual rate of 12.9% over the last nine years, compared to just 9.6% at Deere & Company. The shares trade for just under 10 times trailing earnings and pay a 2.3% dividend yield.

Taking a short position in the Industrial Select Sector SPDR (XLI) against relatively stronger names in the space is a good way to hedge global market risk. The fund diversifies exposure throughout the sector with 61 companies in aerospace & defense (25.3%), machinery (21.5%), industrial conglomerates (20.3%) and transportation (18.4%). While I am generally a proponent of the diversified sector funds, the industrial fund is priced relatively expensively at 13 times the trailing earnings of holdings and outperformance in stronger names will be diluted by weaker stocks. The fund pays a 2.0% dividend yield and charges a 0.18% expense ratio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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