Cyclicals Switching Gears

If Coke no longer is it, the stock market needs a new leader.

Would you believe: USX-U.S. Steel?

The steel giant’s shares continue to hover near their 52-week-high price, while Coca-Cola is down 17% from its peak.

In fact, gritty industrial stocks in general have been outperforming consumer-products titans like Coke, Colgate-Palmolive and Walt Disney in recent months, after trailing those issues in the first four months of the year.

Consider the trends in two big-stock indexes tracked by brokerage Morgan Stanley Dean Witter:

* The brokerage’s 30-stock consumer-company index has gained just 2.8% over the last three months, a return depressed in part by the sharp recent declines in Coke, Gillette and other former high fliers.

* By contrast, Morgan’s 30-stock “cyclical” company index--heavy with industrial names like USX-U.S. Steel, Caterpillar, Deere, Union Carbide, PPG Industries and other companies whose fortunes generally are tied to the economy’s growth and recession cycles--has jumped 13.5% over the last three months.

Year-to-date, the cyclical/industrial-company index is up 29%, far exceeding the 19% rise in the consumer-company index.

That’s a big switch from 1995-96. In that two-year period, the consumer index soared 61% while the cyclical/industrial index rose 33%.

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What’s behind the leadership switch? Some investors have grown wary of the consumer stocks’ relatively high price-to-earnings ratios--especially given the recent warnings from both Coke and Gillette that their earnings growth will be less than expected in the second half of the year.

In 1995, 1996 and for much of this year, investors have been willing to pay 20 to 30 times earnings or more for consumer giants because their earnings growth was considered so dependable. Now that dependability is being called into question.

Meanwhile, cyclical/industrial stocks are catching investors’ attention in part because of their low price-to-earnings ratios, at least compared with many consumer issues. At its current price of $35.06 a share, for example, USX-U.S. Steel is priced at just 8.5 times analysts’ mean earnings estimate of $4.11 a share for 1997.

Deere, the farm machinery giant, sells for 15 times estimated 1997 earnings. Coke, by contrast, is still priced at 36 times estimated 1997 earnings.

Of course, as veteran investors know, cyclical/industrial stocks almost always sell for much lower price-to-earnings ratios than “growth” stocks like Coke. That’s because although Coke may have a weak quarter or two, it isn’t likely to see its earnings implode, even in a recession.

Cyclical stocks, by definition, are hostage to the economy’s cycles. Steel orders dry up when times get tough, but Coke drinkers for the most part keep drinking Coke.

But some Wall Street strategists believe that as long as the stock market remains in a basically bullish mode, investors may continue to clamor for cyclical/industrial names in coming months.

For one thing, many economists believe the U.S. economy will gain steam through the fall. A stronger economy, unless accompanied by dramatically higher interest rates, would be exactly the kind of environment that would suit cyclical/industrial issues.

Peter Canelo, strategist at Morgan Stanley, says he is emphasizing the “earnings-driven sectors of the market” now, which he says include capital goods, basic industries and transportation companies.

Those also are some of the favorites of Douglas Cliggott, U.S. equity strategist for J.P. Morgan Securities in New York. Not only are cyclical/industrial issues looking more appealing on a price-to-earnings basis, he says, but many of those companies may be able to surprise investors with additional cost-cutting that boosts earnings.

“We think there’s still a tremendous amount of cost savings to be squeezed out of many industries,” Cliggott says.

The risks? As always, the biggest one is that the economy would suddenly begin to careen toward recession. That could gut cyclical/industrial stocks in a hurry.

If you like the cyclical/industrial stock story, the best place to find those issues is in “value”-oriented mutual funds that typically seek out low-P/E stocks.

For more focused bets, check out some of the Fidelity Select sector funds, including Industrial Equipment (up 23.6% year-to-date), Chemicals (up 18.1%) and Industrial Materials (up 9.9%). But note: Fidelity Select funds have 3% sales loads.

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Briefly: Richard McCabe, technical-markets chief at Merrill Lynch & Co., points out that by one measure, the stock market has recently been stronger than at any time since 1991. In the week ended Aug. 1, 82% of the stocks trading on the New York Stock Exchange were above their 200-day moving averages, McCabe says. That’s the best showing in six years.

Despite the market’s latest pullback, McCabe adds that indexes like the Dow industrials tend to peak six to 12 months after the top is reached in such “internal-strength” measures as the one measuring the number of stocks above their 200-day moving averages. . . .

The new tax law, with its cut in the top capital gains tax rate to 20% from 28%, was expected to make dividends even less important to many investors. As if the poor electric utility sector needed something else to make investors shun it. The Dow Jones utility stock index is the only major stock index to show a loss this year: It’s down 1% year-to-date. . . .

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Consumer vs. Industrial

Multinational consumer-products stocks such as Coca-Cola and Gillette have lost their luster in recent weeks, while major industrial stocks such as Union Carbide and USX-U.S. Steel have continued to gain ground. Trends in two Morgan Stanley indexes, one tracking 30 big consumer stocks and one tracking 30 big industrial and “cyclical” issues; weekly closes and latest:

MONDAY

CONSUMER: 399.4

INDUSTRIAL: 501.8

Source: Bloomberg News