Cyclical stocks are pricing in high expectations for economic growth this year. How these shares perform in the coming weeks relative to stable growth stocks may be the early word on that outlook.

William Hester, CFA
February 2004
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The group most surprised by the US economy's 8.2 percent annualized growth spurt in last year's third quarter was economists. The least surprised should have been investors in cyclical stocks.

That's because the shares of cyclical companies - whose fortunes are tied most closely to economic growth - climbed 80 percent (trough-to-peak) from last March through the end of the year, according to an index tracked by Morgan Stanley. That's double what the S&P 500 index returned over the same 10 months. It was an impressive advance, rarely wavering from its continuous climb.

The advance was also broad. Nearly a third of the 30 companies in the Morgan Stanley Cyclical Index doubled in value. The shares of U.S. Steel, North America's largest steel producer, jumped over 200 percent. Phelps Dodge, an auto parts maker, rose 155 percent and U.S. retailer Sears, Roebuck climbed 140 percent. The worst performing company - International Paper - gained 28 percent.

The excitement was fueled partly by expectations for faster earnings growth due to a rebounding economy. Profits for cyclical companies fell slightly in the second quarter and then rebounded 8 percent in the third quarter. Fourth quarter profits are coming in stronger. For the 46 cyclical companies in the S&P 500 index that have announced fourth quarter results, earnings are up 21.3 percent over the same quarter of 2002.

Welcome to a cyclical stock's life. When the economy is heating up and there is demand for basic commodities, hydraulic excavators, computer accessories, and new washing machines, the shares of the companies that sell these products frequently boom.

The risk for investors, though, is the potential for that rate of growth to slow and begin to deflate stock values. The prices of cyclical stocks climbed faster last year than their earnings leaving the P/E multiple on Morgan Stanley's index at 29, up from 21 this time last year.

That helps explain why investors in these stocks are nervous; they've sent the prices of cyclical stocks down 6 percent since January 22.

Just as the strength over the past year has been widespread, so has been the recent weakness. Ford is down 14 percent, Hewlett Packard fell 8 percent, and Caterpillar has fallen 6 percent.

Investors may be pricing in a deceleration of earnings growth. This year - partly based on economic forecasts - cyclical companies should boost earnings by 10 percent in the first quarter compared to the same three-month period a year earlier, say analysts polled by First Call. For the full year, earnings could climb 17 percent above last year's results, both below the growth rate - so far - of the fourth quarter.

If interest wanes in cyclical stocks, where might it increase? Stable growth stocks are often the beneficiaries of unsure investors.

Stable earnings growth comes from selling products customers buy in good times and bad: Johnson and Johnson's Band-Aids, beer from Anheuser Busch, and McDonald's hamburgers. Walgreens, the drug-store chain, has reported improved earnings for 29 consecutive years. That's stable.

Because these two groups flourish in different environments, when one does well, it's often at the expense of the other. That's what happened this time around, too. Stable growth stocks gained 27 percent off last years bottom, according to another Morgan Stanley index, badly trailing that 80 percent gain in cyclical stocks (and a 40 percent trough-to-peak gain in the S&P).

The recent gain in cyclical stocks relative to stable growth stocks has been particularly stark. The chart below shows the ratio of the prices of cyclical stocks to stable growth stocks (an upward trending line represents cyclical companies outperforming stable growth companies). The gain in economically sensitive stocks relative to stable earners is steeper than any time in the past 15 years.

It's been a nice run and, of course, it might continue. Last September, when third quarter results were being announced, cyclical stocks fell 5 percent in just over a week. They recovered and continued their advance upward, correctly forecasting stronger earnings growth in the fourth quarter.

Investors' collective forecast about the rate of profit growth is usually reflected in prices. To keep tabs on these forecasts, watch to see if investors opt for companies that deliver earnings with speed or stability.

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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