Industrial stocks have enjoyed an impressive run recently. The gains seem to have run out of steam, however, and losses could hit them in the near term.
Industrial Select Sector SPDR
exchange-traded fund (XLI), home to names such as
(UNP), and the major U.S. airlines, has gained about 19% since its lowest close of the year on Sept. 30. The main driver has been that a declining rate of inflation has compelled the Federal Reserve to reduce interest-rate hikes, which are meant to squelch inflation by dampening economic demand. Slowing rate hikes mean there’s an end in sight to the impending economic destruction. When markets see the bottom in growth, the quantity of goods and services demanded will resume rising, which is usually positive for industrials.
Buying those stocks now isn’t a great idea.
For starters, industrial stocks look like they’ve topped out for the moment. The XLI’s price is about $98, and had topped out at just over $100 many times since early 2021. That means there’s a whole batch of sellers coming in at that level to knock the price down—and the fund dropped from around $102 recently this fall. This means that traders and investors need a reason to buy more at this higher level—and they don’t see that reason yet. To be sure, industrials have outperformed the
by a greater margin in past decades than they have recently, according to Bank of America, and they could reach that level of outperformance again.
But before these stocks break out to new highs, they might need to come back down to earth first. The XLI has outperformed the S&P 500 by almost 15 percentage points this year. Meanwhile, the Institute of Supply Chain Management’s Purchasing Managers Index, which measures the degree of economic activity, has recently headed into contraction territory. Historically, industrial-stock outperformance is highly correlated to the ISM PMI according to 22V Research, meaning that a lower PMI should bring about underperformance from industrials. When this divergence between the two happens, as it has lately, industrial stocks tend to underperform the market for a period thereafter.
Reasons for the poor preference could materialize fairly soon.
Expectations for Industrial companies’ earnings might be a little too high. The aggregate analyst expectations for earnings per share from companies in XLI is $4.79 for this year, according to FactSet, and $5.48 for 2023, which would be about 33% higher than 2019’s $4.09, before all the inflation.
Companies such as Caterpillar have benefited from higher prices, which have spurred sales growth and profit-margin expansion, leading to high earnings-per-share growth. Those results could down a bit, especially since the Fed is trying to reduce the extent of price increases. Plus, the lowered demand likely means a hit to sales volumes, or the quantity of goods sold. To be sure, the XLI has seen its 2023 earnings-per-share estimate drop by almost 10% in the past six months according to FactSet, but the downward revisions could continue from here as the economy often feels the pain of higher rates on a delay.
There may be plenty of promising industrial stocks with strong businesses out there, but for now those stocks are facing some heightened near-term risk. A better entry point might emerge soon.
Write to Jacob Sonenshine at firstname.lastname@example.org