Who Knew? Industrial Stocks Are Leading the Market Rally

After spending much of the year as a market laggard, industrial stocks have rebounded over the past three months and are considered a good bet to keep moving higher.

Natalie Behring | Bloomberg | Getty Images

While industrials are only in the middle of the pack overall for 2009, with about a 6 percent gain, the group has about doubled the performance of the broader market since the most recent lows in July.

The resurgence has dovetailed with gains in oil, gold and a slew of other commodities and has helped add another 16 percent to an already aggressive market rally. Improvements in the economy and sharp cost-cutting measures also have buoyed the group's performance.

The sector has displayed vast improvement in a number of areas, exemplified by Wednesday's reading on industrial production that showed an increase of 0.8 percent, the second consecutive monthly rise.

"A lot of economic indicators out there are quite positive within the industrial sector, and a lot of the anecdotal stories that you hear on a company-by-company basis are relatively positive in the industrial manufacturing sector," said Paul Larson, stock analyst at Morningstar. "That is a relatively strong area right now."

The SPDR Industrial Select ETF has gained about 32 percent since its most recent closing low on July 9, easily outpacing broader market gains that also have been driven by commodity rises in energy and precious metals.

General Electric is the largest holding in the ETF, and the CNBC.com parent itself has gained 58 percent since mid-July. Other significant components of the XLI are United Parcel Service and United Technologies.

But smaller companies in the space also are benefiting from the runup in commodities.

UBS raised its rating Wednesday on chemical maker Olin and paint maker PPG Industries because of price increases in both chlorine and caustic soda. The companies should benefit from stronger margins and revenue from the price hikes, UBS said.

"What we're seeing right now is a rising tide lifting all boats," said Richard Sparks, senior analyst at Schaeffer's Investment Research in Cincinnati. "Industrial production numbers are suggesting that the economy is regaining its footing. That's going to be good for all companies."

Trading floors also were buzzing Wednesday with news that Joy Global , a heavy equipment manufacturer, told a market conference that the global outlook for coal is strong, boosting the environment for mining-related industries.

Options traders on Tuesday, perhaps in anticipation of the news, were buying up short-term September calls for Joy that would make money if the company's stock pushes up to $45.60, sending shares up 5 percent. The gains carried over to Wednesday.

"The pricing of commodities is very positive for the industrial sector," said Tom Schrader, managing director of principal trading for Stifel Nicolaus in Baltimore. "It looks like everyone is pretty rosy on industrial growth."

Investors also have been flocking to companies that are protecting their bottom line even though top-line revenue growth has been weak. Many of the big industrial names fall into that category.

Earnings preannouncements have been largely positive so far, giving rise to more hope that when third-quarter reports start coming out the positive moves from the first half of the year should continue.

"It's remarkable how much a lot of these companies have been able to take out of the system to maintain profitability," Larson said. "You're seeing a lot of companies that are experiencing 15 to 20 percent revenue declines and their profits are only down 15 to 20 percent. You're not seeing fixed-cost deleveraging because they're able to slim down dramatically enough to offset the revenue decline, which is frankly quite surprising."

To be sure, there are some landmines in the space.

Many analysts continue to pound the correction drum, saying the entire market is overbought and could see a snapback soon.

Robert W. Baird downgraded five industrial process companies on Wednesday, saying they were overvalued and likely to do no better than perform in-line with the Standard & Poor's 500.

The affected companies are ITT , Pentair , Idex , Colfax and Altra Holdings, all cut to "neutral" from "outperform."

"We recommend owning companies with positive secular, as opposed to cyclical, drivers," the firm said in a research note to clients.

"The early-cycle companies have rallied rather sharply," added David Kelson, partner and portfolio manager at Talon Asset Management in Chicago. "The late-cycle companies have not rallied to the same degree but are starting to show some life. So I think you can look at industrials where there's some opportunities on the buying side and selling side, depending on the segment."

At the same time, the probability of industrials aggressively controlling costs has investors confident the sector's rally can continue.

"They're not going to be very eager to ramp up costs again quickly, even if they see conditions improving," Sparks says. "We need to see the economy truly back on its feet. It's going to take a few quarters for companies to feel comfortable raising expense levels again."