September 27, 2019 / 4:35 PM / 2 months ago

Cyclical shares key to determining endurance of U.S. stock rally

NEW YORK (Reuters) - Improved economic sentiment in recent weeks has lifted shares of U.S. financial, energy, industrial and materials companies, but analysts are sharply divided on whether that optimism is warranted.

FILE PHOTO: Traders work on the floor at the New York Stock Exchange (NYSE) in New York, U.S., August 6, 2019. REUTERS/Brendan McDermid/File Photo

The performance of these cyclical sectors over the next few months, as a result, could signal whether U.S. stocks are catching a second wind or eking out their last gains ahead of an economic downturn.

“They’re anchored to improving expectations on the economy and the macro backdrop,” said Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets in New York. “If we’re wrong on the economy, and this is not a turning point but a tipping point, everything else goes down.”

In August, economic angst ratcheted up as trade tensions between the United States and China re-escalated. Those worries snowballed early this month as the Institute for Supply Management’s closely watched index of U.S. manufacturing activity contracted for the first time in three years during the previous month.

Since then, though, economic data have looked rosier.

U.S. industrial production in August rose 0.6%, its biggest monthly gain in a year, and IHS Markit’s flash PMI reading showed an uptick in U.S. manufacturing for September. Home sales have also improved of late, signaling a potential rebound for the sluggish housing market. Retail sales remain robust, further supporting the notion of a steady U.S. economy.

Accordingly, cyclical stocks have perked up. Financial .SPSY, energy .SPNY and materials .SPLRCM shares have significantly lagged the broader S&P 500 this year. But in September, S&P 500 energy and financial shares have each gained 4.3% and materials shares have advanced 2.5%. All have bested the S&P 500's .SPX 1.7% month-to-date gain.

Industrial shares .SPLRCI, which have outperformed the S&P 500 year-to-date, have also been strong, rising 3.1% in September.

Graphic: Cyclicals rally in September, here

The possibility of impeachment proceedings against U.S. President Donald Trump have boosted defensive utilities .SPLRCU, real estate .SPLRCR and consumer staples .SPLRCS shares in the past few days. Even so, a sustained boost in growth indicators could lend further support to shares that tend to track how the economy is doing.

“In the U.S., it feels like there is some stabilization in the economic data,” said Seema Shah, chief strategist at Principal Global Investors in London. “This could be the time to start increasing exposure to cyclicals.”

Others have also become more favorable on cyclical stocks. Jefferies now recommends energy shares, while RBC Capital Markets upgraded its rating on industrial shares to “overweight.”

Relatively low valuations also make certain cyclical shares appealing, said Steven DeSanctis, equity strategist at Jefferies. The 12-month forward price-to-earnings (PE) ratios for financials and industrials, at 12.3 and 16.1 respectively, are well below their late 2017 and early 2018 peaks and lower than the 17.1 forward PE for the S&P 500. Meanwhile, the forward PE ratio for utilities, at 19.8, has zoomed past its 2018 levels as investors have turned to defensive shares during bouts of market volatility.

“There’s a huge gap between cyclical and defensive stuff,” DeSanctis said. “One would think it’s time for a little bit of a shift.”

Graphic: Playing defense is pricy, but cyclicals are cheap, here

Not all market watchers are convinced that economic data support a sustained run in cyclicals, however. In a recent note, UBS chief market strategist Francois Trahan argued that the recent rebound in economic indicators would be short-lived, given the decline in corporate earnings growth and the lingering effects of the Federal Reserve’s interest rate hikes in 2018.

Mona Mahajan, U.S. investment strategist at Allianz Global Investors, is likewise skeptical. She suggests investors tilt their portfolios toward defensive shares as well as growth-oriented stocks in the technology .SPLRCT and communication services .SPLRCL sectors.

“For the cyclical story to really work, you would need to see stabilization in the PMI data and a resolution around trade,” Mahajan said. “We’re seeing softening rhetoric, but we haven’t seen tariffs being pulled back.”

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Indeed, the progression of U.S.-China trade relations may determine which camp is correct. For instance, Shah of Principal anticipates that U.S. economic growth will reach its low at the end of the year and then rebound. But “that’s with the assumption that geopolitical events don’t get out of hand,” she said.

Even if economic data weakened further, some cyclical stocks could still outperform, said Calvasina of RBC Capital Markets. Because the shares have languished in comparison to the S&P 500 at large over the past few years, they are likely to incur relatively small losses on the way down.

“If everything is about to fall apart, it could still be good for a deep value, cyclical trade,” Calvasina said. “Late in the economic expansion, you have to be on alert for a style shift.”

Reporting by April Joyner; Editing by Alden Bentley and Nick Zieminski

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