Flight to cyclical industrial stocks could prove fleeting

Last Monday saw some of the most volatile trading on Wall Street for many months - even by The Street's standards. The Dow Jones Industrial Average, which reflects trading in the top 30 stocks, first rose by a staggering 275 points before losing all those gains to close down 50 points on the day.

But it was on the Nasdaq electronic market that the most extraordinary trading took place, with massive sell-offs of Internet and technology stocks driving the main Nasdaq index down by 5.6 per cent, the second biggest fall in the electronic market's history.

Internet stocks like Yahoo and America On Line suffered the worst from the dramatic shift in sentiment, falling by almost 20 per cent on the day.

Many in the market believe this was long overdue and that Internet stocks had been driven up to ludicrous levels - especially as most of this group are years from generating profits.

So has the bubble burst for the techno/pharma sector and is the recent move back into the cyclical industrial stocks more than just a short-term blip?

The cyclical stocks have staged a number of rallies in recent years, only to fizzle out as investors put their faith in the techno/ pharma sector. But analysts at home and abroad believe that there are solid grounds to believe this latest revival in the cyclicals may be more than just a temporary phenomenon. If that proves to be the case, then it will be a cause for rejoicing for shareholders in companies like CRH and Smurfit, not to mention the small to medium-sized companies in the Irish stock market which have suffered badly since the introduction of the euro.

Mr Robbie Kelleher of Davy and Mr John Conroy of NCB both believe that the resurgence of the cyclical stocks - which has seen Smurfit rise almost 70 per cent since the beginning of the year (albeit from a very low base) and CRH gain more than 23 per cent) - is firmly rooted in a much improved global economic outlook.

"Cyclical stocks are very dependent on the real economies. At the beginning of this year, there was serious concern about a slowdown in the US, a possible recession in Britain, weak growth in Europe and fears that the worst may not be over for the Far East economies. Now there is no sign of a slowdown in the US, Britain is nowhere near as bad as many people feared and Europe is okay. There are really good earnings stories out there for investors," says Mr Kelleher.

He also believes the current shift towards the industrials will benefit the Irish small/ mid-cap sector, which has heavily underperformed the blue chips. Since the end of 1996, the top 10 Irish companies have outperformed the small caps by 70 per cent and now is the time to reduce the ratings gap. "We find the current ratings gap extreme and would be an aggressive buyer of small cap versus large cap," Mr Kelleher says.

Mr Conroy of NCB was in broad agreement. "The US economy is outperforming without signs of inflationary pressure, the UK looks like getting a soft landing and there is a muted recovery in Europe and all that bodes well for economic growth and demand. There is a lot of cash out there driving the cyclicals and this removes some of the valuation anomalies that have arisen," he says.

All this helps the cyclical stocks that tend to benefit proportionately more from an improvement in the economy. As a group, they tend to be highly operationally-geared; a small rise in revenue growth means a big improvement in earnings.

Mr Conroy, however, sounded a note of caution, warning that there is a danger possible upward moves in interest rates have not been priced into shares.

The interest rate environment is benign after the recent cut in rates by the European Central Bank and no signs from the US Federal Reserve that there is any concern about inflation. But if increased demand for goods produced by the cyclical industrial sector translates into higher factory gate prices and higher inflation, then there is the prospect of the Fed tightening credit at some time in the future, Mr Conroy suggests.

The prospect of a recovery has also helped focus the markets' attention on the relatively low level to which the stocks of such companies had fallen.

The appetite for growth stocks that investors have displayed in the mid-to-late 1990s has meant that a vast valuation differential has developed between stocks in a few favoured sectors - information technology, telecommunications, pharmaceuticals - and the rest of the market.

Technology, pharmaceutical and telecommunications businesses all enjoy the advantage that their industries are growing rapidly. Not only does this make it a lot easier for them to continue increasing profits, it also means that they stand out from the rest of the market, and accordingly attract a premium rating.

But while some premium might be justified, has the market taken it too far?

So far the adjustment in relative valuations that has been under way in stock markets around the world this month has only amounted to a reversal of some big historical anomalies - the equity market equivalent of a bargain-basement sale.

It is far from clear whether cyclical companies will justify this enthusiasm - or whether the very forces that have produced this turnaround could spell an end to the bull market.

Firstly, it could spell the end of the momentum-investing style that has proved highly conducive to the bull market, particularly on Wall Street. Momentum investing - where buyers acquire shares when a company's performance is good, but bail out at the first hint of trouble - has worked well in the technology sector, with much of the buying coming from a new army of small shareholders.

Secondly, the change in sentiment signals a belief that the deflationary pressures that squeezed the developed world's producers for so long are about to ease. But that implies they will eventually be able to rebuild their profit margins by raising their prices.

The last time companies involved in basic materials like chemicals, paper and metals did better than the stock market at large was in 1993, when the US economy was surging out of recession. By early the following year, however, the Federal Reserve slammed on the inflationary brakes by raising interest rates. The cyclical upturn was short that time; it may prove so again.