Time to start planning for the next rally

09/15/2009 8:30 am EST


Jim Jubak

Founder and Editor, JubakPicks.com

It’s time to consider shifting gears.

 Instead of chasing the winners of the last stock market rally—the one that’s still going on--I think you should start putting some money into the potential winners of the next move up.

Even if that means leaving the last 10% of this rally on the table and being distressingly early for the next move.

Remember all that rhetoric about how nobody can call the absolute top or bottom of a stock market? Well, this is your chance to back up those words with some cash.

 Here’s your choice in the stock market right now as I see it.

  1. You can continue to chase the trends that have worked since this rally stated in March. You know the ones.

  2. Or you can take a look ahead and try to buy into sectors that are still relatively cheap but that you think will be the next to rally.

That’s a tough decision.

On the one hand, I think the sectors that have paced the market in 2009 still have room to run. They could well be 10% higher by the end of the year. But some of them are looking very, very pricy. And that could spell trouble if the economic recovery isn’t as strong as investors now dream.

On the other hand, lagging sectors remain relatively cheap—so they won’t totally destroy your portfolio if the economy is more sluggish than everyone expects and stocks slump. But they haven’t shown much of a pulse in 2009. If you invest in these sectors, you’re hoping that the economy gets strong enough so that growth spills out of the winners of 2009 and into these laggards.

What to do? What to do?

Here’s what I recommend.

I think it’s too late to chase most of the stars of the last rally. Some of these sectors are now so expensive that they’ve discounted the great majority of the good news from any likely economic recovery. In the case of the most expensive of these sectors you’re paying way too much for their remaining upside.

I’d avoid the priciest while still putting some cash to work in the winning sectors where prices aren’t out of line.

But it is time to try to get ahead of the market by putting some of the cash you’ve still got on the sidelines—even after my recent buy of Johnson Controls (JCI) Jubak’s Picks has still 31% in cash—to work in the sectors that are still cheap and that are likely to lead the next stage of any rally. (Don’t have any cash on the sidelines? Then I’d suggest a little profit taking and some sector re-allocation. I’ll get to some specifics on that by the end of this column.)

(I think this system also offers a useful guide to moving in and out of the 10 trends in the Jubak Picks 50. I’ll post on how to use this system on that portfolio tomorrow.)

The kind of portfolio reallocation I’m recommending isn’t as simple as buying what’s hot or buying what’s cheap. But you can get a good start on the job by using some of the data that Standard & Poor’s makes available about the ten sectors that make up its S&P 500 Stock Index ($INX).

(You can find the data that I’m using by downloading a spreadsheet (the one called “Operating earnings by GICS sector S&P 500”) from this S&P webpage http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_500/2,3,2,2,0,0,0,0,0,1,6,0,0,0,0,0.html )

We all know what sectors have led the market higher in the rally that started in March. If you need a refresher, just check out of the performance of the S&P sector ETFs (Exchange traded funds). As of the close on September 10, the Materials Select Sector SPDR (XLB), you know the ETF that’s heavy on such suppliers of raw materials as Freeport McMoRan Copper & Gold (FCX), Alcoa (AA), and Nucor (NUE), is up 36.3% in 2009. The Consumer Discretionary Select SPDR (XLY) is up 26.8%. The Financial Sector Select SPDR (XLF) is up 17.5%. And the Technology Sector Select SPDR is up 34.8%.

And if, like me, you own some stocks that done less well, you can probably name at least some of the lagging sectors. (Although this rally has lifted almost all boats off the bottom of the ocean, so even the laggards in solidly in the black.) The Health Care Sector Select SPDR (XLV) is up 10% for 2009. The Consumer Staples Sector Select SPDR (XLP) is up 7%. The Energy Sector Select SPDR (XLE) is up 12.8%. The Industrials Sector Select SPDR (XLI) is up 13.2%. And the Utilities Sector Select SPDR (XLU) is up 1.8%.

If you’re familiar with Sam Stovall’s work on linking sector rotation with the economic cycle, the names in each group aren’t a complete surprise. What Stovall found when he went back to studying the way that the stock market anticipates economic turns is that on average certain sectors can be counted on to outperform the market at different stages in the economic cycle as defined by the National Bureau of Economic Research. (You can find Stovall’s work on sector rotation in his 1996 book Sector Investing.)

So, for example, when the economy is in the early stages of recovery—roughly where we are now, maybe—industrials (near the beginning of this stage of the cycle), basic materials, and energy (near the end of this stage) do well. In the late recovery stage energy stocks (near the beginning of the stage), consumer staples, and services (near the end of the stage) do well.

Those patterns are only true on average and the Great Recession hasn’t been anything like an average example of the economic cycle. The global banking system almost collapsed. Growth—and demand--plunged everywhere in the world. Consumer spending in the world’s largest economy plummeted as unemployment climbed toward 10%. The dollar went from being the refuge of panicked investors to an object of scorn and the world’s weakest currency.

Under the circumstances I think we need to do more than a little fine-tuning of the average sector rotation. The best way to do that is to look at changes in sector price-to earnings ratio, because they are a good indicator of investor sentiment, and analyst projections of future sector earnings, because they are a good indicator of risk. (This system has interesting applications to buying and selling in the long-term Jubak Picks 50 portfolio. I’ll have a post later today on my blog JubakPicks.com that will show how you can use it with that portfolio.)

So for example, using the S&P spreadsheet on price-to-earnings ratios and projected earnings, it’s very clear that the financial sector has gotten very, very pricy in this rally. In 2007 the sector traded at a price-to-earnings ratio of just 17.2, a little less than the P/E ratio for the S&P 500 as a whole at 17.8.

In 2008 as earnings in the sector collapsed into negative ground, the P/E/ ratio became meaningless.

In the rally of 2009 as earnings recovered a bit—at least enough to make it into positive territory—the rally took the sector up to a nose-bleed P/E of 40.6.

That valuation isn’t completely insane because Wall Street analysts believe that financial stocks will grow earnings per share by 141% in 2010. Remember that stock prices anticipate the future. That would take earnings to $11.10 a share for the sector. And bring the P/E. ratio on projected 2010 earnings down to just 16.8.

If those projections for 2010 earnings turn out to be correct, rather than massively over-priced, financial stocks are trading pretty much where they were in 2007 before everything blew up.

Are you enthusiastic about putting money into the financial sector on that basis?

If analysts are right, and financial stocks grow earnings by 141% in 2010, the sector is reasonably priced now. (That is, if you think 2007’s valuation, when banks were pumping up profits using every bit of leverage they could beg, borrow or steal, was reasonable.)

That means to make a decent profit in the sector, financial stocks will have to move up to “unreasonably priced.”

On the other side, the down side, of that there’s the very real possibility that analysts are wrong. Bank regulators for the G20 group of nations recently decided to make banks raise a whole lot more of the least risky—and hardest to raise—Tier 1 capital—in 2010 or 2011. That would certainly put a crimp in earnings per share.

As would current trends in the commercial lending market that raise the real possibility of another round of bank failures that could freeze sectors of the financial market again.

No, thanks. Don’t care for those odds right now.

Not every sector that has led the rally now looks like a bad risk/reward proposition. Technology (and here I have to use S&P’s information technology grouping rather than the technology ETF because that’s the way S&P tracks earnings), for example, has moved up in this rally to a price-to-earnings ratio of just 20.4. I say just because that’s still significantly below the price-to-earnings ratio in 2007 of 23.7. And because analysts are counting on the stocks in this sector to grow earnings per share by a comparatively modest 32.3% in 2010.

On the same basis I’d call the consumer discretionary sector still decently value but say that the materials sector is pushing valuations higher than I want to go.

And how about the laggards. Most interesting to me are energy, industrials, and health care.

Energy should be coming into its own if we’re in the late part of the early stage of an economic recovery. And because of the collapse in global demand in the Great Recession stocks in the sector are comparatively cheap. Industrials would be among the leaders at this stage of an average economic cycle but because of the severity of the global collapse in demand that brought sector leaders such as General Motors (GM) to bankruptcy, investors have been more hesitant that average to enter the sector. Health care had been savaged before the recession by a wave of patent expirations that put earnings into doubt for all the big drug companies and then put into deep freeze by the uncertainties created by the Obama administration’s efforts to reform the health care system.

Here’s how all this translates into real action. I don’t especially trust the almost universal optimism on the economy so I’m not going to rush to put a lot of new money to work. We could certainly get a decent correction in the next few months if it looks like the economy is going to take longer to rebound than the consensus now believes.

I don’t think any correction would be huge so I’m willing to stick it out. But the uncertainty gives me a certain caution about moving quickly.

 Over the next few weeks I’m going to take advantage of what I think is the end stage of this rally to take some money out of the more overvalued sectors and put it to work in the laggards that I think will lead the next stage of the stock market recovery. In some sectors such as energy that will mean getting a bit less defensive and trading an ExxonMobil (XOM) for a Devon Energy (DVN) or a Statoil Hydro (STO), for example. (See my head to head blog post comparing Statoil with Brazil’s Petrobras (PBR) http://jubakpicks.com/2009/08/25/head-to-head-petrobras-vs-statoilhydro/)  In other sectors, such as industrials I’ll continue to add to my exposure as I have with the recent purchase of Johnson Controls.

I’m going to take my time at this reallocation, but in the end I think I’ll have a portfolio that’s set to profit from the next rally rather than chasing this one.

Jim Jubak owns share in the following companies mentioned in this story: Devon Energy, Johnson Controls, Petrobras, and StatoilHydro.
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