Industrial Stocks: A Smokestack Comeback?

At the very least, it's clear that U.S. manufacturing has stopped its dramatic decline. That reality is reflected in economic data, recent corporate earnings reports, and especially stock prices.

According to data provider Capital IQ, stocks classified as industrial are up 27% in the last three months, beating the broader Standard & Poor's 500-stock index by more than six points. Only the materials sector—which is closely linked to industrial activity—and the financial sector have done better over the last quarter.

But though the stock market signal is clear, other data can be muddy. On Oct. 15, the U.S. Empire State index surged from a reading of 18.88 in September to 34.57 in August, much better than economists were expecting. But on the same day, the U.S. Philadelphia Fed index, which measures economic activity in a different region, slipped from 14.1 in September to 11.5 in October.

Economists said the Empire State reading showed manufacturing accelerating the recovery that began in the summer, while the Philly number suggested progress was slowing a bit.

Upcoming Earnings Reports Earnings reports may give investors a better sense of what's really going on. Conglomerate General Electric (GE), which includes large industrial businesses, reports earnings on Oct. 16. More big industrial names report results the following week. On Oct. 20, United Technologies (UTX) and Caterpillar (CAT) unveil earnings. On Oct. 22, package-delivery giant UPS (UPS) reports, followed on Oct. 23 by Honeywell (HON) and Nucor (NUE).

Investors and economists will be looking to see how strongly these firms are recovering from the recession, and whether it can continue. "The real question is how strong the recovery is going to be over the next several months," says Keith Hembre, chief economist at First American Funds.

There are a few reasons to be optimistic. Manufacturing is jumping off a very low base. One way to measure that is freight traffic. Longbow Research analyst Lee Klaskow noted Oct. 15 that Union Pacific (UNP) intermodal rail volumes are now up 37.7% from March. For all railroads, so-called originated intermodal volumes are at their highest point of the year.

Since the economic turmoil of late 2008 and early 2009, companies have been liquidating their inventories at a rapid rate. Eventually, those inventories need to be replenished. Deutsche Bank (DB) Chief U.S. Economist Joseph LaVorgna reiterated his case Oct. 15 "about the significant contribution inventories will make to GDP growth over the next few quarters."

Weak Dollar Helps Exports Developments overseas also bode well for U.S. industry. A weak dollar makes U.S. products more competitive on the global marketplace. (Though a weak dollar can also make manufacturing more expensive by, for example, raising the costs of imported fuel.)

Judging by the U.S. Dollar Index, which measures the greenback against a basket of world currencies, the dollar has lost 16% of its value since its recent peak in March.

"The U.S. needs to export more and import less, and a weaker dollar will help it do that," says Michele Gambera, chief economist at Ibbotson Associates, a subsidiary of Morningstar (MORN).

Also, the world economy seems to be recovering from recession faster than the U.S. economy, a good sign for companies like Caterpillar that sell lots of products overseas.

Exports "could be the key sustaining force in the manufacturing expansion," Hembre says.

Gary Wolfer, chief economist at Univest Wealth Management (UVSP), argues the world—and U.S.—economy is set to bounce back strongly.

"To me, a key indicator right now, besides the stock market, is energy prices," he says. Oil, which traded up 3.5% to almost $78 per barrel on Oct. 15, is being driven higher not by weather or inventory problems but by "the perception of a very strong global rebound."

PPG Industries Expects Modest Recovery An early test of how industry is doing came from an Oct. 15 earnings report from PPG Industries (PPG), which makes paints, coatings, glass, and other products. Though sales were down 24% from a year ago, earnings were 96¢ per share, up from 70¢ a year ago. That pushed PPG's stock 0.9% higher to 62.08, capping an 88% run since mid-March.

PPG Chairman and Chief Executive Charles Bunch sounded cautiously optimistic about global economic conditions. Translation of currency from abroad to the U.S., Bunch said in a statement, "which had been a headwind for PPG all year thus far, will likely shift to a tailwind," he said. However, he added, "we anticipate only modest improvement in the overall economy" in the fourth quarter.

The U.S. economy needs industrial firms like PPG, Caterpillar, and UPS to do well, if only because so many other parts of the U.S. economy—from finance to retail to home construction—remain depressed.

Gambera worries the recovery is fragile. "We are all expecting that the recession is over," he says. But, "if there is not a bit more action in manufacturing and retail, I'm afraid we will continue being on the edge."

Industrial firms might not need a blockbuster third quarter to keep hopes for an economic recovery alive. But any sign of a weakening in manufacturing demand ahead would be deeply troubling to bullish investors and optimistic economists.

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