Not all stocks in battered sectors will bounce back in a second-half economic upturn. Here are some that could be left behind
Most market players expect that the Federal Reserve, after lowering rates one more time on Apr. 30, will pause to assess the impact of its monetary easing policy and assorted other moves on the economy. The prospect of a hiatus in the Fed's rate-cut cycle, along with a notable decline in market volatility and a smaller-than-expected number of lowered profit forecasts from U.S. companies—not to mention eager anticipation of the first tax-rebate checks—have a lot of people convinced that any U.S. recession will be short and shallow and that a recovery may begin as early as late summer.
Some investors believe certain industries and stocks would automatically profit from an economic rebound, based on the notion that the rising tide will lift all boats in the group. But not all companies in recovery-ready industries will benefit. There are some that are likely to disappoint investors, due either to sector- and company-specific problems or to a weakening in key markets outside the U.S. that have been a major source of revenue growth.
Stocks in the financial and consumer discretionary sectors immediately come to mind as recovery candidates when investors think the economy may be on the mend, and technology names may also seem to be good bets.
How you invest "comes down to your core beliefs. If you believe growth is going to gradually get better in the second half [of 2008] and that we've seen the worst of negative [earnings] revisions, then you want to own classic cyclicals," says Alec Young, equity strategist at Standard & Poor's Equity Research. "Right now there's a lot of uncertainty about that, and that's why the market keeps churning around."
That uncertainty is reflected in the Standard & Poor's 500-stock index, which has repeatedly failed to break above the 1400 level in recent weeks, notes Young. He points to another challenge for the market: "There's still a lot of bad news on the economic front." Indeed, on Apr. 29, the Conference Board said its Consumer Confidence Index fell to a five-year low in April, and the S&P/Case-Shiller index, which measures the average price of homes in the 20 largest U.S. metropolitan areas, fell 12.7% in February from a year ago, the biggest drop since its inception in 2001.
Still, investors may have itchy trigger fingers while waiting for a potential recovery. There is an enormous amount of cash currently parked in money-market funds and CDs earning very low interest rates. Those low-yield instruments make investors hungry for higher returns, says Chris Sunderland, a senior portfolio manager in the global fundamental strategies group at State Street Global Advisors (STT) in Boston.
Beware Retail Stocks
Sunderland worries that investors have been too quick to start discounting an economic rebound and recommends they wait four to six months to play what he and others predict will be a temporary recovery, which may last for only a few quarters before the economy slips into a deeper recession in 2009.
"The most likely to disappoint could in fact be retail stocks. We're going to have $4 [per gallon] gasoline at the pump this summer," he says. "That, coupled with home prices continuing to deteriorate and declining consumer sentiment, all weigh on the consumer."
Men's clothing retailers such as Jos. A. Bank Clothiers (JOSB) and Men's Wearhouse (MW) will continue to have difficulty, predicts Bill Rutherford, president of Rutherford Investment Management in Portland, Ore. "Men's clothing is the first to turn down and the last to recover" from a slowdown, he says. "Jos. A Bank was already doing badly and will continue to do badly."
David Joy, chief investment strategist at RiverSource Investments in Boston, says he expects some luxury retailers to disappoint since "there's very little pent-up demand." If an unwinding of the extraordinary amount of debt that has been created occurs, that will affect even those in upper-income brackets, he adds.
Split Decision: Automakers
Although they usually count as industrials, automotive manufacturers are an example of the consumer discretionary stocks that Stuart Schweitzer, global markets strategist at JPMorgan Private Bank (JPM) cites as likely to benefit as people gain spending power from their tax rebates. He expects automakers to offer special incentives to coincide with the rebates, which would essentially double the value of the rebates.
While Joy at RiverSource says he likes Ford Motor (F) "because of specific things being done there," he thinks automakers are not going to do very well in a recovery.
Financial Stocks May Disappoint
The market may have high hopes for the financial sector while the economy is repairing, but regional banks won't do as well as some investors may hope, warns Sunderland at State Street. Although net interest margins have begun to improve as the yield curve steepens, banks aren't benefiting as much as they might be expected to because the expanding margins "are being offset by continuing chargeoffs for defaults."
Young at S&P says that even though the major writedowns related to subprime mortgage exposure may be past, financial stocks are likely to stay on the defensive. "[They] would be getting secondary consumer knock-on effects from credit cards, auto loans, and personal lines of credit, so they would feel secondary ripple effects…because the consumer is now really starting to feel it," he says.
Young predicts consumer-oriented banks, such as Capital One Financial (COF), could be hit, compared with providers such as American Express (AXP) that cater to higher-end personal accounts and corporate accounts. "Capital One is a classic example of one people would buy to play a recovery and could get burned [by] down the road," he says.
Another problem for regional banks: They will face writedowns for losses on commercial and construction loans and have a harder time raising capital than the big investment banks have had, warns Rutherford. "They do have their deposit base, but I think they'll still have more pain to be recognized in their lending portfolios," he says.
The investment banks are also likely to fare worse than investors expect even if economic conditions improve, since key revenue drivers such as M&A activity and equity underwriting will remain well below 2007 levels, Young warns.
Another factor investors should bear in mind: Historically, growth in developed economies overseas has tended to slow down as the U.S. economy rebounds from a slump, says Bruce McCain, chief investment strategist at Key Private Bank (KEY) in Cleveland. He says he's seeing "substantial weakening in a number of foreign markets," such as Europe, where central banks continue to fight inflation by keeping interest rates at higher levels. "If those overseas economies decline, that could mean recovery [in the U.S.] is going to take a lot longer," he says.
The companies whose earnings have weathered the financial turmoil of the past few quarters with help from export revenues will probably hit a bump when foreign markets slow down. Consumer staples outfits such as Pepsico (PEP), with 44% of its revenue coming from overseas, and Coca-Cola (KO), which earns 74% of its revenue outside the U.S., tend to be spread out over emerging markets and developed markets and are showing more signs of slowing, says McCain. "They may perform far less well than some of the health-care companies that get more of their revenue from domestic sources," he says.
Technology is another sector that's expected to do well as economic concerns subside, but some tech names are subject to similar risks because of their reliance on foreign markets. Those tend to be big, brand-name stocks rather than smaller niche players, McCain says. Intel (INTC), which derives more than three-quarters of its sales overseas, is more vulnerable because of its reliance on non-U.S. sales, according to McCain.
"If overseas markets start to turn down more as the U.S. recovers…that suggests Intel could start to have a much more difficult time than you would think looking at them now and in recent months," he predicts.
John Lau, an analyst at Jefferies (JEF) who covers technology stocks, disagrees, however, and points out that any slowing in foreign developed markets would be offset by Intel's exposure to emerging markets, which account for more than 40% of the chipmaker's total revenue. Lau, who has a buy rating on Intel, says he believes emerging markets are growing at more than twice the rate of mature markets around the world and "will continue to expand in new infrastructure because it's a long-term investment."
Even if a downturn in the more mature foreign economies doesn't hurt U.S. companies that depend on exports, a stronger dollar could. RiverSource's Joy believes the dollar is as much as 20% undervalued against some foreign currencies and says that companies with exposure to markets overseas could come under pressure as the Fed switches from its easing cycle to raising interest rates to fight inflation.
If the Fed starts to boost rates in response to continuing inflation pressures, financials will be especially vulnerable, which isn't the way investors have been viewing them under a recovery scenario, says McCain. In prior recoveries, the dollar typically has firmed and long-term interest rates have remained steady. "If we got high and rising long-term rates and the dollar continued to weaken, that looks like it would be particularly difficult for financials," he says.
So while a second-half rebound may materialize, it may only prove to be a short-lived oasis before another economic dry spell. Investors may want to adjust their strategies accordingly.