The stock market's rebound has created an unlikely winner. One of last year’s lagging sectors — the industrials — is leading the way with its best quarter-to-date performance in a decade. The group has surged nearly 18% this year, outperforming all other areas of the market, something that hasn’t happened since the end of 2013, according to CNBC.

But the rapid rise may be too much, too soon. Uncertainty about the Chinese economy and the outcome of trade talks with the U.S. could trigger a serious pullback, dragging down industrial stocks such as Union Pacific Corp. (UNP), Deere & Co. (DE), 3M Co. (MMM), Caterpillar Inc. (CAT) and United Technologies Corp. (UTX).

“I think the movement in the industrials really has been a sigh-of-relief rally that we’re not headed into a recession. But this group is going to be really based on what happens with China,” Point of View Wealth Management’s John Petrides told CNBC. “Not only the trade tariffs, but is the Chinese economy slowing in addition to or something other than the trade tariffs?”

Too Far Too Fast?

(Industrial Stocks Vs. Market YTD)

·           +17.7%: Industrial Select Sector SPDR Fund (XLI)

·           +10.5%: S&P 500 Index

Source: CNN Money (as of 10am 2/21)

What it Means for Investors

Many industrial companies have significant exposure to China's slowing economy and the trade dispute. As trade war rhetoric intensified throughout 2018, a key indicator of China's industrial activity declined from 51.5 to 49.4 between January and December. A reading of 50 indicates zero manufacturing growth. The official deadline to complete a trade deal is March 1, which would avoid a new round of sharp increases in of U.S. tariffs on Chinese imports. President Trump recently stated that he may extend the deadline if needed. 

Piper Jaffray’s Craig Johnson is also cautious about the industrial sector’s recent comeback. From a technical analysis point of view, he thinks the current rally in the Industrial Select Sector SPDR Fund could retest old highs reached back in September and January of 2018. But if the index doesn’t push past those resistance levels, then an ominous triple top could be in the making. “I’m a little bit more skeptical," says Johnston. "This has not been an area where I’ve been overweight with our clients. I’ve been looking at other areas like technology and consumer cyclicals to really play the bounce back in the market.”

What’s Next

The lack of clarity about the outcome of the U.S.–China trade talks means these stocks may still be vulnerable to wild swings. This means investors may have be be especially adept at selecting which of these stocks can surmount any upheaval and outperform longterm.

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