A Roadmap For The Market

9/22/2014


My sense of direction is terrible. Tell me to go southeast, and I'll ask you to stop speaking in tongues. But I'm quick to pull out the road atlas or stop for help — no wounded pride here.

With so many diverging opinions on the direction of the stock market, it's easy to lose your bearings. By instinct, I find myself reaching for a roadmap.

The Dow Theory, interpreted by my colleagues, is one effective guide. I also consider the business cycle, tracked by the National Bureau of Economic Research.

U.S. BUSINESS CYCLES SINCE 1980
The economy last peaked in December 2007, capping off a 73-month period of expansion.
Peak Month
Trough Month
Expansion
Length
(No. Of
Months
Trough To
Peak)
Recession
Length
(No. Of
Months
Peak To
Trough)
December 2007
June 2009
73
18
March 2001
November 2001
120
8
July 1990
March 1991
92
8
July 1981
November 1982
12
16
January 1980
July 1980
58 *
6
Avg. For 1945-2009 (11 Cycles)
58
11
* Prior trough occurred in March 1975.
Source: The National Bureau of Economic Research

After surviving the worst downturn since World War II (an 18-month stretch that ended in June 2009), we now stand 63 months away from the last trough, according to NBRE. In the 11 completed business cycles since 1945, expansionary periods have averaged 58 months, though the past three cycles have each topped 72 months of expansion.

Different sectors tend to lead the stock market at different points of the business cycle. Identifying our position in the cycle can help us anticipate which sectors are likely to regain favor.

SECTOR ROTATION THROUGH THE CYCLE
Fidelity Investments identified the following sectors to target and avoid for each phase of the business cycle, based on returns for the 3,000 largest U.S. stocks from 1962 to 2010.
Early Cycle
Midcycle
Late Cycle
Recession
Sectors
To Target
Discretionary
Industrials
Staples
Staples
Financials
Tech
Energy
Health care
Industrials
Health care
Telecom
Materials
Materials
Utilities
Technology
Utilities
 
Sectors
To Avoid
Energy
Materials
Discretionary
Discretionary
Telecom
Utilities
Technology
Industrials
Utilities
Technology

The CFA Institute breaks the business cycle into five stages, as detailed in the March 10 issue of the Forecasts, as well as any other issue dating back to 2008.

Fidelity Investments, armed with data from 1962 to 2010 for the top 3,000 U.S. stocks by market value, considers four phases: early cycle, midcycle, late cycle, and recession.

The U.S. has occupied the midcycle phase since the second half of 2010, says Fidelity. Midcycles tend to be the longest phase, typically lasting four years. Differences in sector performance tend to be narrower in this phase, though economically sensitive stocks often do best, particularly industrial and technology companies. This is also the phase when market corrections most frequently occur.

In the late cycle, a phase that usually lasts 18 months, growth moderates further. Stocks of companies protected against inflation, especially those dealing in raw materials, tend to outperform. Investors also tend to migrate toward sectors with defensive characteristics.

Now four years old, could the midcycle be nearing an end? Three of the top four sectors in 2014 — health care, materials, and utilities — are noted by Fidelity for performing well in the late cycle. Returns for the consumer discretionary sector rank last for the year, consistent with many past late cycles.

SECTOR RETURNS FOR CURRENT CYCLE
S&P 1500 Sectors
Annualized
Return For
Current
Midcycle *
(%)
Sector
Rank
Year-
To-Date
Return
(%)
Sector
Rank
Consumer discretionary
20
1
3
10
Health care
20
2
16
1
Industrials
17
3
4
9
Technology
16
4
14
3
Consumer staples
15
5
8
5
Materials
15
6
9
4
Energy
15
7
8
7
Telecom services
14
8
6
8
Financials
13
9
8
6
Utilities
13
10
14
2
S&P 1500 Index
16
9
* Started July 2010, according to Fidelity.

That said, sector leadership rotates frequently in the midcycle phase. Moreover, several economic indicators, highlighted in the Sept. 8 issue, suggest it might take a while before this expansion shows up in our rearview mirror.

We try to strike the right balance between acknowledging current road markers and looking ahead to the approaching horizon. With that in mind, our favorite stocks in strong midcycle sectors include Apple ($102; AAPL), Lam Research ($75; LRCX), ManpowerGroup ($76; MAN), and Union Pacific ($110; UNP). Top picks in key late-cycle sectors are Aetna ($83; AET), CVS Health ($82; CVS), Kroger ($52; KR), and Whiting Petroleum ($84; WLL).


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