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Investment Strategy

The Great Rotation

By Elliott H. Gue, on Jun. 19, 2013

Editor’s Note: Elliott Gue and Roger Conrad will host a FREE webinar on Oct. 15, 2013, at 2:00 p.m. to discuss their outlook for the stock market and economy and their top themes and stocks for 2014. Can’t attend live? Registering will also enable you to replay the event at your leisure.

On Oct. 4, 2011, Moody’s Investor Service cut Italy’s sovereign-debt rating for the first time in almost two decades, sending yields on bonds issued by fiscally troubled EU governments soaring and Continental stock markets tumbling. EU leaders floundered to resolve the situation and stabilize Europe’s shaky banking system, raising the specter of another devastating credit crunch.  

In the US, a spate of weak economic data and a protracted battle between President Barack Obama and Congressional Republicans over the US debt ceiling catalyzed a vicious 18 percent selloff in the S&P 500 in early August. After a brief bounce in September, the market resumed its slide into early October.

But stocks often bottom when the economic outlook and financial conditions look bleakest. True to form, the S&P 500 hit an intraday low of 1074.77 on Oct. 4, 2011, before embarking on an impressive rally. After this inflection point, the benchmark index has posted a total return of almost 50 percent.

Source: Bloomberg

Though welcome, this rally has been unusual in one key respect: Stocks and industries with a reputation for their defensive qualities and modest exposure to economic conditions have led the way.

Conventional wisdom holds that investors should buy shares of companies that produce consumer staples when the economy sputters. The health care sector is another safe haven. In contrast, when the economy strengthens and the stock market rallies, the traditional playbook calls for investors to allocate capital to cyclical groups such as energy, technology, financials and industrials.

Market history supports this strategy. For example, during the bull market that stretched from March 2003 to October 2007, the S&P 500 generated an average annual return of 16.1 percent, topping the 12.5 percent annual gain posted by the S&P 500 Consumer Staples Index and the S&P 500 Health Care Index’s 8.4 percent annual profit. Meanwhile, the energy and information technology components of the S&P 500 soared 247.9 percent and 110.4 percent, respectively.

But since October 2011, the S&P 500 Consumer Staples Index has delivered a 57 percent return to investors, while the S&P 500 Health Care Index has rewarded investors with a 41.3 percent gain. Over this period, the S&P 500 itself generated a total return of 49.6 percent. Flying in the face of conventional wisdom, defensive sectors have held their own or outperformed.

This strength peaked in the first quarter of 2013, when the S&P 500 rallied by 10.6 percent and the top-performing components were health care, consumer staples and utilities. Notable laggards during this period included the information-technology and basic-materials sectors.

Low-Beta Bubble

Beta is a statistical measure of a stock’s volatility relative to the S&P 500. Shares with a beta of 1 tend to track the broader market. Stocks with a beta of less than 1 are less volatile than the S&P 500, while those with a beta that’s greater than 1 are more volatile.

Investors historically have gravitated toward low-beta names in bear markets; these stocks are less exposed to economic conditions and downturns in the major equity indexes. Higher-beta names are usually regarded as an investors’ best bet during bull markets.

Source: Bloomberg

This graph tracks the performance of the 125 S&P 500 members that exhibited the lowest beta in each month, from April 1993 to present. Our proprietary Low-Beta Index generated a total return of about 522 percent over this period, compared to the 436 percent gain generated by the parent benchmark.

Much of this outperformance reflects the resilience of low-beta names during the 2001-03 and 2007-09 bear markets. When the stock market tanked in the early 2000s, the low-beta names held their ground, while high-flying technology stocks and other cyclical fare suffered a severe rout.

Although this group of stocks wasn’t immune to the massive selloff that occurred during the most recent financial crisis, the losses suffered were modest relative to the S&P 500; the benchmark index’s low-beta members had a much shallower hole from which to dig themselves.

These days, the low-beta rally looks long in the tooth. After the group’s recent tear, many traditionally defensive sectors trade at record premiums relative to the S&P 500 as a whole.

Source: Bloomberg

The S&P 500 Consumer Staples Index currently trades at more than 18 times its constituents’ trailing 12-month earnings–a roughly 14 percent premium to the S&P 500’s valuation. Since 1996, this defensive sector has traded at a 4 percent premium to the broader market.

Underlying business fundamentals don’t support these frothy valuations; Wall Street analysts’ consensus estimates call for companies in the S&P 500 Consumer Staples Index to grow their earnings by 6.8 percent over the next 12 months, compared to 10.3 percent for the S&P 500.

The higher dividend yields that consumer staples stocks offers investors have become a hot commodity in this low-yield environment. But at these levels, the S&P 500 Consumer Staples Index sports a dividend yield of 2.86 percent–not that far removed from the 2.07 percent current return offered by the S&P 500. This yield spread represents a significant compression from differentials in prior years.

Whereas valuations appear stretched in defensive segments of the market, stocks in cyclical industries appear cheap.

Source: Bloomberg

Information-technology stocks led the market’s surge in late-1990s. At the peak of the bubble, this component of the S&P 500 traded at a roughly 3-to-1 valuation premium to the benchmark index. Today, the S&P 500 Information Technology Index trades at a slight discount to its parent index on a price-to-earnings basis–near the low end of its 13-year valuation range.

Using the same valuation metric, the S&P 500 Energy Index has traded at an average discount of 13 percent to the parent index, reflecting the group’s cyclical earnings and recession-induced selloffs. But with the price of Brent crude oil above $100 per barrel and global economic growth likely to pick up in the back half of 2013, energy stocks look inexpensive.

Equally important, business fundamentals appear strong in both of these cyclical sectors. Technology stocks in the S&P 500 are projected to grow their earnings by almost 20 percent over the coming year–nearly double analysts’ expectations for the S&P 500 as a whole. Although the Bloomberg consensus estimate calls for the S&P 500 Energy Index to post only modest earnings growth this year, the sector includes several pockets of strength and earnings estimates for 2014 appear close to a bottom.

Timing the Turn

British economist John Maynard Keynes once quipped that the market can remain irrational a lot longer than investors can remain solvent. One of the biggest mistakes an investor can make is to buy a stock or sector just because it looks cheap or to sell a stock because it looks expensive.  Stocks can remain undervalued a lot longer than you expect.

Plenty of investors warned that technology stocks looked expensive in 1997. Those who avoided the group likely underperformed the broader market for three years before their bearish view was finally vindicated in mid-2000.

In this case, however, we’re beginning to see signs of a broad rotation out of low-beta defensive groups and into cyclical names. Thus far in the second quarter, financials, industrials and technology stocks have outperformed the S&P 500; consumer staples, on the other hand, rank among the worst performers.

We expect this reallocation to accelerate as the US economy exits the summer soft patch and strengthens heading into early 2014. (For more details on our outlook, see US Economy Faces Summer Slowdown before Springing into 2014.) As investors anticipate this turn, expect cyclical names to outperform.

That being said, investing is never an all-or-nothing proposition. There are still plenty of attractive stocks in defensive market groups that offer ample upside and lots of cyclical names that we wouldn’t touch despite their inexpensive valuations.

But our first additions to the Wealth Builders Portfolio, which we profile in Riding the Cycle, hail from the energy, technology and financial sectors. As we populate the portfolio’s consumer staples and health care sleeves, we’ll exercise due caution and focus on stocks that stand to benefit from major upside catalysts.

Elliott H. Gue is founder of Capitalist Times and Energy & Income Advisor.

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