Get to Know This Market's Sweet Spot

02/24/2011 1:00 pm EST

Focus: MARKETS

James Stack

President, Stack Financial Management

Energy and industrials have performed best of late, as they tend to do in the later stages of a bull market, writes James Stack of InvesTech Research.

This bull market is approaching its second birthday in March, and now is a good time to step back and assess where we are in the market cycle.

There are three important considerations to keep in mind right now:

  1. The recovery is on firmer footing than most investors believe.
  2. This is still a bull market, and a remarkably strong one at that.
  3. Imbalances are appearing that could change the outlook by the end of 2011.

The chart below was developed by InvesTech based on our own research as well as studies by Ned Davis Research and Standard & Poor’s. It shows the three stages of a stock-market cycle, along with the sectors that have historically outperformed during each stage.

chart
Click to Enlarge

  • Stage I encompasses the transition from late bear market to early bull market, and this is when cyclical sectors such as financials, technology, and consumer discretionary tend to outperform. Remember that the stock market generally leads an economic recovery, and as consumers and businesses start to feel better about the economy, they begin spending again in the more discretionary areas where they have held off on purchases during the bear market.
  • Stage II is the mid- to late bull market, when economic growth is more firmly established. Materials and industrials tend to outperform during this stage, and are usually joined by energy and telecom stocks as the bull market matures.
  • In Stage III, as the bull market runs out of steam, the nondiscretionary sector—health care, consumer staples, and utilities—are usually the most resilient. These companies provide products and services that people need regardless of how bad they feel about the economy or the stock market. Since we are now about two years into this bull market, it’s likely we are entering Stage II on this graph (the shaded portion of the line). And recent sector performance appears to support that assessment.

The Numbers Fit Almost Perfectly
As we look at performance, the chart below shows the sectors and their returns over the past 12-month, six-month and three-month periods.

chart
Click to Enlarge

The early bull-market sectors (Stage I) are at the top, mid- to late bull-market sectors (Stage II) are in the middle, and the bear-market resilient sectors (Stage III) are at the bottom. The white highlighted areas show where the various sectors have outperformed the S&P 500 for the period, and we can see that there are some apparent transitions in leadership underway.

  • The Stage I sectors were particularly strong in 2009, during the earliest stage of this bull market. While they are still holding up, recent performance has been mixed.
  • The Stage II sectors are where strength is now emerging—particularly energy and industrials, which have the strongest gains over the past three months.
  • Stage III sectors continue to underperform, but it’s important to note that these sectors were more stable than their cyclical cousins when the bull market suffered a significant correction last summer.

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