S&P's Chemical Reaction

S&P stays neutral even though the relative performance chart shows improvement in the group's share-price performance in the coming months

While I was flipping through the rolling 12-month relative strength charts for the nearly 140 subindustry indexes in the Standard & Poor's Composite 1500 index (consisting of the S&P 500, S&P MidCap 400, and S&&P SmallCap 600 indexes), both the S&P Commodity Chemical and Diversified Chemical charts popped out to me as turnaround candidates.

Investors have begun to rotate back into these areas as there may have been overselling earlier this year on concerns for a greater-than-now-expected slowdown in global economic growth. What's more, our forecast for natural gas prices has declined since earlier in the year, so earnings may benefit accordingly. As a result, maybe there is a possibility that these groups have both near- and longer-term outperformance possibilities.

This time around, I chose to focus on Diversified Chemicals, since the index contains the larger players in the four-industry chemicals camp (commodity, diversified, fertilizers, and specialty chemicals). Year to date through Dec. 15, the Diversified Chemicals subindustry index rose 8.2%, vs. a 14.1% advance for the S&P Composite 1500 index.

Different Interests

The subindustry's relative strength has improved recently after bottoming in the first quarter, as shown in the accompanying chart. 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 subindustry index's 17-year mean relative strength.

Richard O'Reilly, chief financial officer, covers this subindustry for S&P. Unfortunately, he does not share my interest in this group. O'Reilly is neutral on the fundamental outlook for diversified chemicals, although he has positive outlooks for several component companies.

Post-Hurricane Output

O'Reilly notes that prices for commodity petrochemicals and plastics declined during the 2006 fourth quarter after stabilizing in the third quarter, as customers delayed purchases in anticipation of further declines in energy and feedstock (i.e., input materials) costs. Prices had climbed in late 2005 following plant shutdowns caused by Gulf Coast hurricanes.

S&P expects annual production by the chemical industry, as measured by the Federal Reserve's production index for chemicals and products, to grow 2% in 2006, after a flat performance in 2005. Chemical output in October, 2006, at 106.1 (2002 = 100), was up 11.8% from the hurricane-depressed level of the year-earlier period; industry production by mid-2006 had more than recovered from last fall's downturn caused by hurricane-related disruptions.

In October, 2006, the industry's utilization rate was 77%, up from the year-earlier 72.7% rate. The producer price index for chemicals and products in October, 2006, was at 208.1 (1982 = 100), up 2.9% from the year-earlier level.

Soda Ash Price Hike

O'Reilly believes that feedstock costs will continue to be both historically high and volatile, driven by energy prices. The American Chemistry Council's price index for feedstock costs rose for the third consecutive year in 2005, but in October, 2006, the index was 10% below its year-earlier level.

Chlor-alkali prices, which had shown continued gains since the 2004 second quarter as the U.S. industry was operating at over 90% of capacity, also eased in the fourth quarter, while makers of titanium pigment have struggled to boost prices this year. Soda ash makers successfully implemented a large price increase in 2006 for the second straight year, as the industry is essentially sold-out in the U.S.

The largest individual companies in the group are chemicals-related, but many also have major interests in other industries.

The factors that influence the sales, earnings, and share prices of companies in this industry, in our view, are similar to those in the commodity and specialty chemicals industries. O'Reilly believes that trends in the non-chemical businesses could dampen or magnify the cyclical factors that affect chemicals.

So there you have it. Even though the relative performance chart points to an improvement in the group's share-price performance in the coming months, S&P's fundamental outlook remains neutral. O'Reilly's top name in the group: FMC (FMC), which carries a 5 STARS (strong buy) ranking.

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), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).

Industry Company S&P STARS Rank Price (12/15/06)
Agricultural Products Archer-Daniels-Midland (ADM) 4 $33
Apparel, Accessories & Luxury Goods Coach (COH) 5 $43
Broadcasting & Cable TV Comcast (CMCSA) 4 $43
Casinos & Gaming Harrah's Entertainment (HET) 3 $80
Department Stores Federated Dept. Stores (FD) 4 $39
Diversified Metals & Mining Freeport-McMoRan (FCX) 4 $60
Fertilizers & Agricultural Chemicals Monsanto (MON) 2 $51
Integrated Oil & Gas Exxon Mobil (XOM) 5 $77
Integrated Telecommunication Services CenturyTel (CTL) 4 $43
Investment Banking & Brokerage Merrill Lynch (MER) 5 $92
IT Consulting & Other Services SRA Intl. (SRX) 5 $27
Motorcycle Manufacturers Harley-Davidson (HOG) 3 $70
Steel Carpenter Technology (CRS) 4 $110
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