The Outlook Darkens for Metal Benders

INVESTORS LAST YEAR sought to hide in stocks with little exposure to the U.S. housing market and the American consumer. The shares of industrial companies and materials producers fit the bill. The fortunes of these companies were bolstered by global growth in capital spending, while the industries' international sales -- some 40% to 45% of total revenue -- benefited from a weak dollar.

This year may be less kind to both sectors, however, particularly if the U.S. economy slips into recession -- a risk not fully reflected in most industrial and materials shares.
The industrial components of the Standard & Poor's 500 index have returned almost 15% a year for the past five years, while the S&P materials sector has gained an average of 19% annually. Big winners in 2007 included Deere (ticker: DE), up 96% to close at 93.12 on Dec. 31; Honeywell (HON), up 36% to 61.57; Freeport McMoRan Copper & Gold (FCX), up 84% to 102.44, and Alcoa (AA), up 22% to 36.55.

Almost all stocks decline in a recession, except those involved with "special situations" such as restructurings, says David Rosenberg, chief North American economist at Merrill Lynch. Industrials might outperform as they benefit from a weaker dollar, but they will still decline in a recession. "To think that there won't be a spillover into other sectors doesn't line up with historic scrutiny," says Rosenberg, whose indicators put the odds of a recession this year at 60% to 100%.

By his calculations, industrials fall 28% from peak to trough around the time of a recession. At the moment, the S&P industrials are down only 7% from their October high -- thus pricing in a 25% chance of recession. Material stocks typically decline 27% in recession periods; they have fallen only 4% from their peak, also set in October.

Fans of both sectors believe that strong international sales will protect these companies, many of which have been big beneficiaries of China's growth, even if the U.S. economy starts to shrink. But the bulls may be underestimating the knock-on effects of a U.S.-consumer-led slowdown on economies overseas, and forgetting the U.S. consumer accounts for 19% of global gross domestic product.

After years of heady growth, heavy-industry stocks could hit the wall as global growth slows.
Wall Street analysts still see strong earnings gains for both sectors in 2008. The 56 industrial companies in the S&P 500 are likely to lift profits by 12% this year, about on par with '07's estimated 13% growth, according to Thomson Financial. The 28 S&P 500 materials companies could boost earnings 11%, up from an estimated 5% in '07.
Industrial companies currently trade for an average of 15.3 times 2008 estimated earnings, while materials fetch 15.9 times expected profits. Neither valuation is particularly rich, nor do they hint at tougher times ahead. The price/earnings multiples of cyclical companies typically contract as earnings peak and investors begin to discount diminished growth in the future.
Tobias Levkovich, chief U.S. equity strategist at Citigroup, recommends underweighting capital goods and materials stocks. Four indicators he tracks -- trailing price-to-earnings, price-to-book value, enterprise value-to-cash flow and the P/E-to-growth ratio -- suggest industrials are overvalued. He is wary of the materials sector because of its cyclicality; new capacity is coming online in the chemicals industry, and earnings revisions are trending downward throughout the sector.
The former machinery analyst says the flood of capital sluicing into emerging markets in recent years eventually will result in overbuilding, if it hasn't done so already. This will hurt suppliers of raw and finished goods, such as aluminum, iron ore and steel, and manufacturers of transportation, construction and mining equipment. "Excessive money leads to excessive investment," Levkovich says, citing the buildup in petrodollars and foreign-government surpluses. "The amount of money pouring into emerging markets is getting to levels that will come back to bite us."

The Bottom Line:

S&P materials stocks have risen 19% annually, and industrials 15%, for the past five years. Both sectors could see steep declines if the U.S. economy enters a recession.
Ed Shill, chief investment officer of QCI Asset Management in Rochester, N.Y., is underweight industrials and owns no materials stocks. "Virtually any commodity price is trading well above its cost of production," he says.

Shill points to copper, which trades just north of $3 a pound but costs only 75 cents to produce. International growth doesn't have to stop, but merely slow beyond expectations, to hurt these sectors. "My guess is, you'll have a chance to buy these names cheaper," says Shill.
If the U.S. economy is on the threshold of recession, that chance could come soon.