Challenges for Industrial Stocks

Industrial stocks have experienced a significant decline recently, primarily due to concerns over the economy. These stocks are now trading at alarming levels.

The Industrial Select Sector SPDR exchange-traded fund (XLI), which includes major manufacturers such as Honeywell International (HON) and logistics firms FedEx (FDX) and United Parcel Service (UPS), is currently trading around $97. This marks a 12% decrease from its early August peak of just over $110.

The reason for this drop is the market's awareness that the Federal Reserve must, as indicated, maintain high interest rates for a certain period to combat inflation and stabilize the economy. Unfortunately, this will eventually harm demand and restrict companies' spending on large equipment necessary for manufacturing processes. Additionally, reduced consumer demand will negatively impact airlines and transportation companies.

One clear indication that sentiment towards these stocks has deteriorated significantly is that even better-than-expected profits have failed to boost share prices.

For instance, Caterpillar (CAT) reported beating sales and earnings estimates on Tuesday, yet there hasn't been an influx of buyers. In fact, shares are currently in the red during midday trading on Tuesday, reflecting a 20% decline from the record highs achieved in early August.

However, this lack of market response is understandable. Caterpillar's shares, like those of other industrial companies, had already experienced significant growth over the past year, reflecting strong demand. Adding to the negative sentiment, the company reported a year-over-year decrease of nearly $2 billion in its order backlog, indicating a decline in future demand for machinery.

Overall, industrial stocks face a challenging period ahead as concerns over the economy and potential decrease in demand continue to impact their performance.

The Industrials ETF Faces Selling Pressure

In recent years, the industrials ETF has struggled to find solid support from buyers. Despite reaching around $105 earlier this summer, the ETF's shares are now being kept below that threshold due to selling pressure. This selling pressure is a result of the delayed impact of higher interest rates on the economy, which is beginning to manifest in forward-looking indicators found in companies' earnings releases.

The negative influence of selling pressure can be seen in the ETF's 50-day moving average, which has significantly dropped. It currently hovers only slightly above its 200-day moving average. In more robust trading environments, the short-term average should be considerably higher than the longer-term average. This is because, as stocks experience upward momentum, older averages are left at lower levels. The fact that the 50-day average is almost in line with the 200-day average indicates a significant downside movement for the fund. This is due to the market's heightened concerns regarding industrial firms' profitability.

Although selling pressure has been strong, it is expected to diminish at some point. Historical analysis reveals that on two previous occasions when the 50-day moving average approached the 200-day moving average (in 2020 and 2021), the ETF experienced subsequent gains. Furthermore, the current share price remains higher than levels seen during those periods.

However, this does not necessarily guarantee another rally from the current position. It would be prudent for potential investors in industrials to closely monitor how the ETF performs around the mid-$90s range, which it is approaching. Over the past year, this general level has attracted buyers. Yet, if these buyers begin to disappear, it may lead to a further drop in price to around $84, representing a decline of approximately 14% from its current value.

For now, it is advisable to carefully observe how the fund behaves within the mid-$90s range before making any investment decisions.