STRATEGIES

Investors could maximize their portfolios by careful selection of the right sectors for 2013, says James Stack of InvesTech Research.

The new year is off to a strong start, with several market indexes, including the broad-based Wilshire 5000, the blue chip S&P 500, and the small-cap Russell 2000, hitting new bull market highs.

Our key technical indicators in breadth and leadership are still in bullish territory and have trended higher since January 1. Also, the economy remains steady, with increasing evidence of a bottom in the housing market, and the recent ISM manufacturing surveys back in expansion territory.

From a sector perspective as well, this continues to look like a bull market. Historical studies show that sector leadership tends to rotate as market and economic conditions change. We’ve divided the stock market cycle into three stages and listed the sectors that have typically been the market leaders during each stage:

  • Stage I covers the early part of a bull market when Financials, Consumer Discretionary, and Technology stocks are among the first to benefit from improving conditions.
  • Stage II is the mid- to late-bull market period. As the economy swings into full gear, Materials, Industrials, Energy, and Telecom generally see their best growth.
  • Stage III includes bear markets, where defensive Health Care, Consumer Staples, and Utilities tend to be the most resilient areas.

In this four-year old bull market, we expect Stage I stocks to fade as Stage II sectors take the lead. Stage III sectors will likely underperform as long as bull-market strength continues. Over the past three months, sector performance has been fairly consistent with this historical mature bull market pattern.

Stage I Technology group has weakened following strong performance in the early part of the bull market. Stage II Materials and Industrials currently rank among the three top performing sectors. Meanwhile, defensive Stage III Consumer Staples and Utilities remain at the bottom in terms of performance. (Stage I Financials have been an exception to the expected lineup as they continue to show strength after coming off a dismal performance in 2011.)

In spite of this bull market’s age, however, it has been accompanied by one of the most anemic economic recoveries on record, and the past 20 months of mediocre market gains may turn out to be a “pause that refreshes.”

If that’s the case, this bull market could see a second leg develop with resurgence in Stage I sectors, particularly in Financials and Technology. These two sectors rallied strongly coming off the 1994 soft landing. Ironically, Stage III Health Care was also among the market leaders during that period, as worries over the proposed Clinton Health Care Plan subsided.

We could see a similar scenario today if the economy strengthens going forward. Financials are already seeing improvement from the upswing in home sales and mortgage origination, while renewed business confidence could lead to an increase in capital expenditures that would benefit both Technology and Financials. Health Care could also rally as uncertainties surrounding implementation of the Affordable Health Care Act are resolved.

At this point, our Model Fund Portfolio is carefully balanced between cyclical and defensive sectors based on the risks surrounding the year-end fiscal cliff. We have maintained close to market weight in most of the bull market sectors with an overweighting in Stage II Industrials.

However, the Model Fund Portfolio is still significantly underweight in Financials, where we’ve been concerned about residual risk, and there’s currently no exposure in Materials. To balance the bull market sectors, we also have overweight positions in defensive Stage III Health Care and Consumer Staples ETFs.

If early strength continues to indicate a new bull market leg, we will likely be advising the following changes to our current sector allocations in the coming weeks:

  • Increase the Financial ETF position closer to market weighting as the fallout from the financial/housing crisis has eased and Financials are poised to capitalize on improvement in housing and credit markets.
  • Initiate a market weight (2% to 3%) position in Materials to take advantage of the expanding economy and increase in manufacturing activity.
  • Reduce the allocation in defensive Consumer Staples closer to market weighting around 10%.
  • Step up Technology, which is undervalued compared to the last ten years, and potentially Energy, which should rebound if the economy gains more traction.

Although Health Care is defensive, we will likely maintain an overweight in this sector, as it is performing in line with the market and we expect that the worries about the Affordable Health Care Act will start to dissipate.

These changes would tilt our investments back toward the more cyclical sectors to take advantage of a strengthening economy and better position the portfolio for further bull-market gains.

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