A False Reaction to Chemicals?


By Sam Stovall The Standard & Poor's 1500 Commodity Chemicals Index rose 15.1% year to date through Aug. 27, vs. a 0.2% decline for the S&P 1500. In the past 13 weeks alone, this subindustry index jumped 19.2%, vs. a 1.2% drop for the broad market. That performance has helped the group enter S&P's industry momentum list.

As can be seen in the relative-strength chart below (which compares the rolling 12-month price performance for chemicals with the S&P 1500), this subindustry index began to pick up steam during the second quarter of this year after treading water for about a year. But now that the relative strength line has moved above its "normal band," as defined by one

standard deviation above and below its average relative price performance since 1990, is much of the move over?

Well, Richard O'Reilly, CFA, S&P's Chemicals analyst, advises most investors to stay away from the group. He notes that S&P's investment outlook for the S&P Commodity Chemicals subindustry -- its three current members are Lyondell Chemical (LYO), Georgia Gulf (GGC), and Wellman (WLM) -- is slightly negative, based on valuations of the individual stocks in the subindex and concerns over high feedstock costs for the chemicals industry -- despite signs of a strengthening U.S. economy.

O'Reilly notes that commodity chemical producers in 2003 felt the adverse impact of a surge early in the year in energy and feedstock costs. After some erosion in selling prices for petrochemicals in the second half of 2003, producers achieved price hikes in the first half of 2004, although O'Reilly believes high costs will continue to crimp profit margins. He says the American Chemistry Council's price index for feedstock costs in June, 2004, while off from its record, was still at a historically high level.

With expected normal plant operations, O'Reilly does not see a sharp cyclical margin recovery in the petrochemicals industry. S&P recommends that investors focus on those companies that have little or no exposure to these products or will benefit from price declines. The analyst believes that a trend of industry consolidation will likely continue as part of an effort to reduce costs.

SOME STRENGTHENING. S&P expects production for the chemicals industry, as measured by the Federal Reserve's production index for chemicals and products, to climb moderately during 2004, after a virtually flat performance in 2003. Chemical output in June, 2004, at 110.9 (1997 = 100), was up 7.2% from a year earlier; industrial production has strengthened broadly since mid-2003. The industry's operating rate in June, 2004, was 75.9% of production capacity, vs. 71.8% a year earlier, but down from the levels of 2000.

The producer price index for chemicals and products in June, 2004, was at a new record of 171.4 (1982 = 100), up 5.7% from a year earlier. Prices for petrochemicals and plastics rose in the first half of 2004, driven by higher feedstock costs. Likewise, chlor-alkali prices have begun to strengthen after some softness since mid-2003, while titanium pigment makers have also succeeded this year in raising prices after disappointing demand in 2003.

To sum up, the Commodity Chemicals subindustry's momentum looks favorable, which may indicate a positive performance in the near-term (at least on a relative basis). But S&P thinks the longer-term fundamentals don't look encouraging, as O'Reilly points out that the subindustry members are all highly leveraged both financially and operationally. None of them carry S&P's top investment rankings of 4 STARS (accumulate) or 5 STARS (buy).

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) and their proxies (the highest STARS-ranked companies in the subindustry index; tie goes to the largest market value) as of August 27, 2004:

Industry

Company

Ticker

STARS

Price

Commodity Chemicals

Lyondell Chemical

LYO

3

$20

Consumer Electronics

Harman International

HAR

5

$95

Diversified Metals & Mining

Peabody Energy

BTU

4

$55

Fertilizers & Agricultural Chemicals

Stott's Co.

SMG

4

$61

Homebuilding

Pulte Homes

PHM

3

$59

Internet Retail

EBay

EBAY

5

$86

Internet Software & Services

Yahoo!

YHOO

3

$29

Multi-Sector Holdings

Leucadia National

LUK

NR

$53

Oil & Gas Refining & Marketing & Transportation

Premcor

PCO

5

$33

Steel

Nucor

NUE

3

$80

Tires & Rubber

Cooper Tire

CTB

3

$23

Wireless Telecommunication Services

Nextel Partners

NXTP

5

$15

Required Disclosures

Standard & Poor's Stock Appreciation Ranking System (STARS)

5-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Accumulate): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate that of the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Avoid): Total return is expected to underperform the total return of the S&P 500 Index, and share price is not anticipated to show a gain.

1-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

As of June 30, 2004, SPIAS and their research analysts have recommended 35.9% of issuers with buy ratings, 52.7% with hold ratings and 11.4% with sell ratings.

All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC (SPIAS). The research and analytical services performed by SPIAS are conducted separately from any other analytical activity of Standard & Poor's. No research analyst that prepares a research report on a subject company has a financial interest in or is associated with that subject company. SPIAS is affiliated with other entities, which may receive compensation for performing services for companies covered by Standard & Poor's Equity Research Services.

Disclaimers

This material is based upon information that Standard & Poor's considers to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions, and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Stovall is chief investment strategist for Standard & Poor's


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