By Sam Stovall Shares of manufacturers producing heavy industrial gear appear to be losing steam. Attesting to the decline, the performance of the S&P 1500 Industrial Machinery group has exhibited an erosion in its rolling 12-month relative-strength ranking in the past four weeks.
This subindustry index consists of 35 large-, mid-, and small-cap companies that supply the equipment other businesses need to run their manufacturing operations. The group powered past the broader market in 2004, rising 18.4%, while the S&P 1500 advanced 10%. But the tables have turned thus far in 2005: Year to date through Oct. 28, this subindex fell 7.2%, while the overall market declined just 0.6%.
GLOBAL GLUTS. The rolling 12-month relative-strength price chart (pictured below) depicts the recent weakness. As a reminder, the jagged blue line represents the subindustry index's rolling 52-week price performance as compared with the 52-week performance for the S&P 1500. Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line represents a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the subindex's 14-year mean relative strength.
The chart tells one story. But should investors take a bearish stance based on the industry's fundamentals? To find out, I checked with Anthony Fiore, S&P's industrial machinery analyst.
Fiore believes companies in this industry have fared well in 2005, due to solid economic growth, a favorable interest-rate environment, and pent-up replacement demand. Longer term, however, S&P thinks that large gluts in global industrial-production capacity could hamper earnings growth for many years. S&P is keeping its neutral fundamental outlook, as Fiore believes the positive operating fundamentals he foresees over the next 12 months are already reflected in industry stock prices.
SQUEEZED MARGINS? S&P expects continued growth in sales and profits for companies in the subindex in 2005, albeit at a slower pace than last year. In addition, so far this year, most manufacturers, with the exception of makers of some of the more commoditized products, have demonstrated a modest amount of pricing power via surcharges and select price increases to help cope with rising raw material costs (particularly for steel and copper). Fiore believes outfits in this industry stand ready to raise prices again in 2006, in the event that raw material costs continue to escalate.
Longer term, S&P believes Asian-driven industrial capacity could negatively affect pricing in the industry. And with corporate profit margins likely to get squeezed in that environment, this could also cause manufacturers to cut back on production, employment levels, and spending on machinery and equipment.
So there you have it. In S&P's view, the subindustry's momentum looks increasingly negative, but according to our industrial machinery analyst, the fundamentals appear strong enough to embrace a neutral outlook. S&P's top selections in the group are Danaher (DHR) and Ingersoll-Rand (IR), each ranked 5 STARS (strong buy).
Source: Standard & Poor's
Industry Momentum List Update
For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative-Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of Oct. 28, 2005.
Diversified Metals & Mining
Fertilizers & Agricultural Chemicals
Health Care Distributors
Health Care Services
Managed Health Care
Oil & Gas Drilling
Oil & Gas Equipment & Services
Oil & Gas Exploration & Production
Oil & Gas Refining & Marketing
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In the U.S.
As of September 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 28.7% of issuers with buy recommendations, 60.3% with hold recommendations and 11.0% with sell recommendations.
As of September 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.8% of issuers with buy recommendations, 44.8% with hold recommendations and 20.4% with sell recommendations.
As of September 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 28.1% of issuers with buy recommendations, 51.1% with hold recommendations and 20.8% with sell recommendations.
As of September 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 29.3% of issuers with buy recommendations, 57.7% with hold recommendations and 13.0% with sell recommendations.
5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.
4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.
3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.
2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.
1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.
Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index and in Asia the S&P Asia 50 Index.
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Stovall is chief investment strategist for Standard & Poor's