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By Larry MacDonald
Globe Investor Magazine, Feb. 6, 2009
The greatest stock-market rally of the past century occurred in the depths of the Great Depression, when the Standard & Poor's 500 index more than doubled during the three months from July to September of 1932. The surge came from extremely oversold conditions: previously, the S&P 500 had tumbled nearly 90 per cent from its peak in 1929.
Flash forward about 80 years. Stocks sold off sharply in 2008, with the S&P 500 dropping 39 per cent, the second-largest yearly drop in its history. As February begins, the market continues to languish near its lows. Governments are pushing stimulus measures like never before, and any early signs of recovery could set off a rally like a spark in a bone-dry forest. So, if equities are the place for the patient investor to be these days, why not get more bang for your buck by tilting your portfolio toward sectors that typically lead moves off the bottom?
"The leaders are usually banks, consumer discretionary and home builders. These equity groups can bottom out as much as 12 months before the stock market," say Donald Dony, principal of Victoria-based D.W. Dony and Associates, an investment consultant who specializes in business-cycle analysis and sector strategies. According to business-cycle analysis, when economic contraction is in its early stages, the best-performing sectors tend to be defensive companies, such as consumer staples - food, beverages, tobacco, and cosmetics - and health care. Fund managers often rotate into this group to preserve capital during a bear market.
As the contraction progresses, interest rates decline and lift stocks in the interest-sensitive groups. Utilities, which normally carry large debt loads, are members of this group. So are banks and mortgage-finance companies, since lower interest rates stimulate lending. Lower interest rates also make it easier to buy discretionary, big-ticket consumption items purchased on credit, such as houses, autos, furniture, and consumer electronics.
As economic contraction gives way to expansion, cyclical stocks begin to turn upward, led by transportation and technology stocks. When companies ramp up production, orders are placed for materials that need to be transported to manufacturing sites while finished products need to be moved to stores. Companies also buy new equipment such as computer systems and hire contractors from firms in the service industries.
In the later stages of expansion, as interest rates are rising, the capital-goods, basic-materials, and energy industries tend to thrive because companies are expanding production capacity and bidding for increasingly scarce resources. Precious-metals stocks typically are stronger at this point as inflationary fears mount.
"Sectors that lead the market after reaching the bottom are, in order of historic strength: information technology, consumer discretionary, financials, industrials and materials," says Don Vialoux, founder of the Tech Talk: Timing the Market website. Danielle Park, a portfolio manager with Barrie, Ont.-based Venable Park Investment Counsel, says the financial and semiconductor sectors usually lead.
"They have to kick in before the bull market enters a sustained advance," she says. These sectors "are perking up a little now" but she remains concerned that the "de-leveraging process now in effect" may hinder progress toward the upside.
Lance Stonecypher, senior sector strategist at Venice, Fla.-based Ned Davis Research Inc., looks for leaders in the "high-beta" sectors. These stocks have a history of rising more during bullish phases and falling more in bearish phases. When bull markets run, risk appetite re-emerges among investors and boosts the riskier, high-beta stocks. Historical studies done by Mr. Stonecypher's firm of the five market upturns since 1974 reveal three of the 10 S&P 500 sectors outperformed in all five: consumer discretionary, technology and industrials. The materials sector outperformed in four of the five upturns.
Another model, the French-Fama three-factor model, shows small-capitalization and value stocks are riskier, volatile investments that command a premium over the long run. Small caps, in theory, outperform during market upswings. Value stocks outperform by falling less during bear markets - but owning value stocks in the bullish phase doesn't work as well as owning growth stocks. Another useful categorization of stocks is by geographic region. Emerging countries are considered to be high-beta markets compared to developed countries. Indeed, Chinese shares are one of the top performing groups since the lows of last fall. Brazilian stocks have also had a good bounce back.
Sectors first in line for government largesse
After the 1932 rally, U.S. stocks retraced their rise, and then rallied strongly again in 1933. A leading sector was grain and alcohol producers - thanks to the repeal of Prohibition. Policy changes often give birth to market leaders. Sometimes they arise in unexpected quarters, but more often, it is the early cyclicals that gain traction because of pump-priming measures. In 2009, the financial, auto, housing, and infrastructure sectors in the United States will be recipients of large dollops of government money. President Barack Obama and Congress have acknowledged the gravity of the downturn and are on record as favouring unprecedented levels of stimulus.
Sectors exhibiting relative strength off the bottom
Non-defensive sectors with relative strength, that is, bigger price increases than other sectors, since November include: Precious metals, emerging markets such as China and Brazil, home-improvement retailers, mortgage-finance companies, home builders, infrastructure, base metals, autos, and semiconductors. The finance sector has been spotty by comparison.
Commentators who have been right before
Each era has its seasoned investors who have made prescient calls. A current example is legendary hedge-fund manager Jim Rogers. Among other things, he forecast in 1999 that a commodity boom was going to unfold over the 2000s. Now, he remains bullish on commodities, including oil, gold and agricultural products, because supply is being curtailed by the credit crunch.
"Commodities will be the place to be if and when we come out of the downturn," he said in a December interview. He also likes the airline industry: It's an extremely beaten-up sector that now appears to be bottoming out because a rash of bankruptcies has cut overcapacity while falling oil prices slash fuel costs.
Special to The Globe and Mail
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