Jubak's Journal Recent articles: • 6 reasons to take your profit now, 7/22/2003 • Judge lets Wall Street off the hook, 7/18/2003 • Don't be fooled by earnings headlines, 7/16/2003 More... | Jubak's Journal One reason the rally may be real For five trading days, cyclical stocks outpaced the tech stocks that were leading the rally. That could signal a wider belief that the economy is expanding. By Jim Jubak For most of the rally that began on March 11, the technology stocks that dominate the Nasdaq Composite Index ($COMPX).Nasdaq Composite Index have outperformed the stodgy industrials of the Dow Jones Industrial Average ($INDU).Dow Jones Industrial Average and the blue chips of the Standard & Poors 500 ($INX). Investors certainly wanted to own Yahoo! But that hasnt been true lately. From July 14 through July 21, Yahoo! is down 4%, and International Paper up 3%. XM Satellite is down 9%, and Caterpillar up 13%.
Look at the declines of Yahoo! and XM Satellite in isolation, and it seems the market is heading into a major correction. But put those declines in the context of gains by International Paper and Caterpillar and it looks much more like the kind of a rotation that investors have wanted to see for the last few months. Five trading days dont make or break a market, but the trend is worth watching. Why is this kind of rotation away from speculative technology stocks and toward stodgy cyclicals potentially good news? Because if this rally is based on evidence of an economic recovery, then the stocks of cyclical companies that are likely to see huge increases in sales if growth kicks in should be leading the move upward. Cyclical candidates Among the Dow stocks, cyclical leadership candidates include aluminum producer Alcoa That underperformance by cyclicals and overperformance by speculative technology stocks led some investors to conclude this wasnt a sustainable rally but simply a bounce in a continuing bear market for equities. Why should cyclical stocks be leading the stock market if the economy is indeed poised for recovery? The short answer: leverage. Fixed costs for things such as plants and machinery make up a high percentage of all costs at companies such as International Paper, and these fixed costs cant be reduced significantly during an economic downturn. When revenue drops, companies like these swing rapidly from profits to huge losses. International Paper, for example, lost $2.37 a share in 2001. But when economic activity picks up, high-fixed-cost companies dont see their overall costs rise as rapidly as revenues. International Paper doesnt increase its fixed costs to run a factory at 80% of capacity instead of 50%. Soaring profits In an upturn, profits at cyclical high-fixed-cost companies soar. Analysts project that International Paper will earn $2.10 in 2004, up almost 150% from projected 2003 earnings. That dwarfs the forecast 60% improvement in earnings in 2004 from 2003 at Yahoo!, with its relatively higher variable costs that rise with revenue. Or the 28% increase in earnings projected for Intel If investors doubt the staying power of the recovery, then its logical that speculative momentum stocks should lead the market in a bounce within a continuing bear. But if they believe that the economic recovery is real, highly leveraged cyclical stocks like Caterpillar, International Paper and Alcoa should lead the market. Rotations can be disconcerting to investors who own the old leaders and see them falter, but a rotation like the one that investors have seen in the stock market over the last week isnt a sign of weakness but instead is evidence that this rally might have staying power. Now investors just have to wait and see if the results of these five trading days are the start of a real trend. Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column. | ||||||||||||||||
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