By Scott Malone - Analysis
BOSTON (Reuters) - The panic about the industrial sector has passed, based on the dramatic rebound of shares from their March lows. But investors need proof demand is stabilizing if the stocks are to hold their gains.
The Standard & Poor's capital goods industry index .GSPIC -- hard hit over the past year -- has risen 58 percent since touching an 11-year low in March, nearly double the 33 percent climb of the broad S&P 500 .SPX.
That rebound has come even as companies across the sector have lowered their 2009 profit targets -- with manufacturers including Caterpillar Inc (CAT.N), Emerson Electric Co (EMR.N) and Rockwell Automation Inc (ROK.N) cutting for a second time.
Wall Street’s concerns about the sector have been eased by a sense that managements have now prepared their companies for a worst-case scenario by aggressively cutting costs and by first-quarter earnings reports that showed stable profit margins in the face of falling revenue.
For sector shares to hold the gains of the last two months, investors will need to see some proof that demand is recovering sufficiently to allow manufacturers to return to profit growth next year, analysts and investors said.
One key question is whether the recession, the worst the United States has seen in decades, will prove to be “V-shaped,” with a rapid recovery, “U-shaped,” with a slower climb back, or “W-shaped,” meaning a brief period of recovery followed by more declines.
“Six months ago the question was how deep will the downturn be and now it’s whether the recovery is going to be a ‘V’ or a ‘U,'” said Matt Collins, a capital goods analyst at Edward Jones. “If it’s not a ‘V,’ I think investors will probably get another good buying opportunity.”
Even after climbing back sharply from its March 6 low, the sector remains down 46 percent over the past 12 months and is now trading at about 13.3 times forecast 2009 earnings. That is a worse performance than the S&P 500, which is down 35 percent and trades at forward price-to-earnings-ratio of 13.8.
“For the stock prices to go any higher from here you have to have a better sense that earnings are going to start to turn,” said Peter Klein, senior portfolio manager at Fifth Third Asset Management in Cleveland. “I don’t think we’re there yet.”
Last month, manufacturers including 3M Co (MMM.N), Honeywell International Inc (HON.N), Textron Inc (TXT.N) and SPX Corp SPW.N aggressively cut their 2009 profit targets. Analysts now expect 2009 profit at those companies to fall 24 percent or more.
Some recovery of demand for capital goods is all but inevitable over the next few months as corporate America finds it can no longer delay some large purchases, Klein said. For a recovery to last, demand outside the United States will need to hold steady, he added.
“It depends on what happens worldwide, in China, Asia and some of the emerging economies,” Klein said. If those economies continue to slump, he added, “You could have a mini-recession in the latter half of 2010 or some time in 2011.”
Over the longer term, though, industrial shares will likely return to a growth footing as investor confidence returns, some investors said.
“At the lows, these stocks got down well past what even the fundamentals may have justified,” said Kent Croft, president of money manager Croft-Leominster in Baltimore. “Companies were planning for the doomsday.”
While another round of cuts to profit forecasts is possible, Croft said, he regarded it as unlikely that it would be dramatic.
“It’s not out of the realm of possibility that we could see further cuts but we’re closer to the bottom of this, of the cuts, than we are toward getting back to a normal level of earnings,” Croft said.
Reporting by Scott Malone; Editing by Steve Orlofsky