Industrial stocks have reached record levels, which is both good news and bad news. They are now one of the two sectors in the S&P 500 to achieve this feat, but their high prices mean that future gains would require positive developments on several fronts.
The Industrial Select Sector SPDR ETF, which includes major players like airlines, Caterpillar, Boeing, FedEx, United Parcel Service, and CSX, has rebounded by over 16% from a multi-month low reached in late October. On Wednesday, the fund closed at a record high of just over $111. This surge was fueled by the Federal Reserve’s announcement that it may cut interest rates next year if inflation continues to drop and economic growth remains sluggish.
Tech stocks have also risen to record highs, making them the only other sector to achieve this milestone.
If the Federal Reserve implements rate cuts, it would ensure the continued expansion of the economy. This would be particularly beneficial for industrial companies since they experience increased sales when there is a rising demand for goods and services.
The stocks have been boosted by expectations that demand will strengthen and profits will rise as a result of sustained economic growth. This is in contrast to sectors like banking and commodities, which have faced lower demand for their products and services, along with issues like higher borrowing costs. Healthcare, consumer staples, and utilities stocks are currently below their peak levels due to the less attractive dividends caused by higher bond yields.
While the industrial stocks reaching record levels is a positive sign, further positive news will be required to push them even higher. Now that the stocks are more expensive, there is an increased risk of declines.
Currently, the industrial fund is trading at a multiple of around 18.8 times the aggregate per-share profits analysts expect its component companies to generate over the next 12 months. This is compared to just under 17 times at the start of the October rally.
INDUSTRIAL STOCKS FACE VALUATION CHALLENGES
The valuation of industrial stocks is currently facing challenges as it falls about 1% below the S&P 500 figure, at just over 19 times. This is a significant comparison because the valuation has rarely exceeded the S&P’s multiple in the past decade, according to FactSet.
While concerns about economic growth emerge, industrials usually trade at a discount of approximately 10% compared to the market. However, the rising valuations in this sector pose a problem as manufacturing activity has not fully recovered from recent demand-related setbacks.
There are potential risks associated with elevated multiples in this sector, as highlighted by Evercore strategist Julian Emanuel.
A key indicator, the Institute of Supply Chain Management’s Manufacturing Index, has consistently remained below 50 for most of this year. This is a significant decline from its peak of just over 60 after the pandemic. Consequently, some companies have experienced falling sales volumes. Despite rising prices, analysts anticipate sales growth of only 0.8% this year.
Given this context, the surge in industrial stock prices puts the sector at risk. If sales and profits fail to meet expectations next year, share prices could experience a significant drop.
Nonetheless, there is some potential for favorable outcomes. If economic growth remains steady and doesn’t decline significantly, the sector’s sales can grow as expected by 5% in 2024. Additionally, if commodity and material costs do not experience a surge like they did in 2022, profit margins have room to rise. This would enable companies to continue their stock buyback programs, leading to an increase in earnings per share by more than 20%.
Furthermore, a further decline in bond yields would also contribute positively to the industrial sector’s performance. Bond yields have already experienced a slide this fall, providing some support to these stocks.
Although industrial stocks should not be abandoned altogether, it is not advisable to expect them to continue their remarkable ascent.