S&P thinks stocks in the tire and rubber group may be overinflated, based on forward fundamentals
From Standard & Poor's Equity ResearchTires are rated for driving conditions, taking into consideration weight, weather, and speed. Since June 30, 2006, the S&P 1500 Tires & Rubber subindustry index—which consists of only two issues, Bandag (BDG) and Goodyear Tire (GT)—raced ahead of the overall market, posting a scorching 110% advance (the highest of all 138 subindustry indexes in the S&P Composite 1500) compared to the 1500's jump of nearly 13%.
Much of this eight-month rapid acceleration was a reversal of the sharp underperformance the index experienced in 2004-05, as it crashed and burned along with the auto manufacturers. Will there likely be continued smooth cruising ahead? Most times, when stock prices turn parabolic (take a look at the accompanying relative performance chart), they sooner or later end up spinning out of control.
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 is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the index's 17-year mean relative strength.
Slight Bounce Back
Efraim Levy covers this group, along with the auto manufacturers and auto-parts companies, for S&P. His fundamental outlook for the tires and rubber subindustry is neutral. He notes that tire margins were pressured in 2006 by increased raw material costs and Asian tire imports. This was partially offset by higher selling prices and a better mix. Levy thinks results in 2007 should benefit from the price increases and any easing in raw material costs.
According to Levy, companies that produce tires for new domestic branded vehicles, especially light trucks, will likely see sales penalized by lower production. With higher gas prices, in S&P's view, contributing to deferred purchases of replacement tires, Levy believes 2006 volume declined 1% to 3%. However, he expects a recovery of 1% to 3% in 2007, as replacement demand rebounds and vehicle production stabilizes.
About three-quarters of the tire shipments for the automotive industry are for replacement tires, with one-quarter for new vehicles. Levy says margins on replacement tires are typically higher than for original equipment tires, as auto makers receive discounts for buying in high volume. Still, he thinks placement of original-equipment tires on a vehicle increases the likelihood consumers will use the same brand tire when they purchase replacement tires.
Some companies have international operations, Levy notes. He believes geographical diversity can help balance performance over economic cycles, as different regions expand or contract at different paces.
So there you have it. The group's chart indicates to us that the recent price appreciation has reached an unsustainable rate of advance, based on forward fundamentals. Both Bandag and Goodyear carry a 3 STARS (hold) ranking from S&P.
Industry Momentum List Update
For regular readers of the Sector Watch column, here's 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), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).
S&P STARS Rank
Apparel, Accessories & Luxury Goods
Auto Parts & Equipment
Johnson Controls (JCI)
Broadcasting & Cable TV
Federated Dept. Stores (FD)
Diversified Metals & Mining
Freeport McMoRan (FCX)
Fertilizers & Agr. Chem.
Integrated Telecom. Svcs.
Investment Banking & Brokerage
Merrill Lynch (MER)
IT Consulting & Other Svcs.
SRA Intl. (SRX)
Avon Products (AVP)
Carpenter Technology (CRS)
Tires & Rubber
Goodyear Tire (GT)