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In Last Quarter of Year, a Focus on What's Working

It's a question as old as investing itself: will good performance last?

New York Stock Exchange Traders
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New York Stock Exchange Traders

The Dow Jones industrial averageand the Standard & Poor's 500 indexare both up more than 5 percent this year, and barring something dramatic will finish in the black.

Much of the gains can be attributed to two sectors: companies that make equipment used in big construction projects, and hotels, restaurants and ritzy clothing stores. Each is up more than 15 percent for the year.

Some stocks in the group are up much more. Anyone who invested in engine-maker Cummins Inc. in early January watched the investment grow by 100 percent. Priceline.com Inc. has jumped about 60 percent.

Normally, performance like that would be a red flag. Chasing after past performance is an investing sin that, like dunking your potato chip twice in dip, everyone is guilty of occasionally. But some money managers say that this could be one time when it pays to keep investing in stocks that are outperforming the market.

The reasons: Much of the world is on a building binge. And consumers with good jobs are starting to spend money again.

Industrial companies are profiting from massive infrastructure spending in emerging markets such as China, Brazil and India. As each country builds roads, tunnels, schools and malls to cater to a growing middle class, they often turn to American corporations for machines, trucks and airplanes.

"The performance of the industrial sector is really a vote of confidence in our ability to export quality products around the world," said Nick Calamos, president of investments at Calamos Asset Management Inc.

Cummins, for example, saw sales of construction equipment more than double in the second quarter, mainly because of building projects in China. Caterpillar has expanded its operations in Brazil and China this year in anticipation of continuing growth.

The weakening dollarcould add additional fuel. While a falling dollar may make it more expensive for Americans to travel abroad, it's a benefit for companies that sell products to international clients whose euros and yens can buy more dollars. "With a falling dollar, a lot of these products that these companies make are going to be cheaper for buyers overseas," said Brian Washkowiak of Talon Asset Management.

"What a lot of people are missing is that they shouldn't be looking at the overall consumer spending numbers but the strong companies that have made it through." -Analyst, Janus Capital Management, Eileen Hoffman

There may be an opportunity, however slight, for increasing revenues in the United States, too. President Obama recently proposed a bill that would call for $50 billion to be spent over six years to rebuild roads, rails and airport runways in the United States, which could translate into additional dollars for the likes of Union Pacific Corp. and Deere & Co .

Industrial companies tend to have strong balance sheets, which means that they aren't taking on a lot of debt that could hurt them should growth not be as strong as anticipated.

"These companies have been very disciplined as they grow," said Mark Schultz, the portfolio manager of the MTB Mid-Cap Growth fund. "If homeowners would have been as disciplined as corporate America, we wouldn't have been struggling with half of the issues that we are."

Household balance sheets are a little murkier. High unemployment is persistent. Home prices are stagnant. And the market is still down about 20 percent from the boom days of 2007. Why, then, would anyone spend money on something as frivolous as a sweater at the Limited?

It was that argument that in the first half of 2009 pushed down so-called consumer discretionary companies — which, unlike retailers such as Wal-Mart , profit from people splurging. This year, however, many of these companies have performed well as consumers made purchases they delayed during the darkest days of the recession. Consumers are expected to spend about $465 billion this holiday season, or about 3 percent more than last year, said Eileen Hoffman, an analyst at Janus Capital Management. That would bring spending back to about the same level as the 2006 holiday season.

The recession also forced many luxury boutiques and small businesses to close, which has translated into greater market share and higher profits for the companies that were able to survive.

"What a lot of people are missing is that they shouldn't be looking at the overall consumer spending numbers but the strong companies that have made it through," Hoffman said. "Even if the overall spending numbers are flat, you're going to get massive market share gains for the ones that are still here."

You only need to go to the mall to see this in action. Macy's is up 44 percent for the year and J.C. Penney Co. is up 27 percent. Shares of teen retailer Abercrombie and Fitch Co. are up 30 percent.

It is true that industrials and discretionary consumer stocks tend to be the first ones that show growth after a recession, which means that their strong performance this year could be seen as something as unnoteworthy as October following September. So an argument can be made that their rallies are following a historical pattern and will peak soon.

But here's something else to consider.

The industrial companies in the S&P 500 index are trading at 15.9 times their expected earnings, which is 20 percent less than the category's average over the past 15 years, said Howard Silverblatt, the senior index analyst at Standard and Poor's. Shares in the consumer spending segment of the index, meanwhile, are trading at 15.3 times their expected earnings, which is 34 percent less than their historical average.

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