Time to Buy the Next Market Leaders

09/15/2009 9:29 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

The current rally has taken the market up more than 50% since March, but it's too late to chase most of the biggest gainers. Instead, you need to look further ahead.

It's time to consider shifting gears.

Instead of chasing the winners of the most recent stock market rally—the one that's still going on—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.

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

On the one hand, 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 pricey. 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 the economy will get strong enough that growth spills out of the winners of 2009 and into these laggards.

What to do? What to do?

Look for Sectors Where Prices Are Reasonable

It's too late to chase most of the stars of the current 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 stocks 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 to work in the sectors that are still cheap and that are likely to lead the next stage of any rally. Even after my recent buy of Johnson Controls, my Jubak Picks portfolio still has 31% in cash. (Don't have any cash on the sidelines? Then I'd suggest a little profit taking and some sector reallocation. I'll get to specifics on that by the end of this column.)

The kind of portfolio reallocation I'm recommending isn't as simple as buying what's hot or 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 Index. (You can find the data I'm using by downloading a spreadsheet called "Operating earnings by GICS sector / S&P 500" from this S&P Web page.)

A Sector Review

We all know which 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 Sept. 10, here are the winners:

ETF

2009 Gain

Materials Select Sector SPDR (XLB)

36.3%

Technology Select Sector SPDR (XLK)

34.8%

Consumer Discretionary Select SPDR (XLY)

26.8%

Financial Select Sector SPDR (XLF)

17.5%

If, like me, you own some stocks that have done less well, you can probably name at least some of the lagging sectors:

ETF

2009 Gain

Health Care Select Sector SPDR (XLV)

10%

Consumer Staples Select Sector SPDR (XLP)

7%

Energy Select Sector SPDR (XLE)

12.8%

Industrials Select Sector SPDR (XLI)

13.2%

Utilities Select Sector SPDR (XLU)

1.8%

If you're familiar with work by Sam Stovall, the chief investment strategist at Standard & Poor's, on linking sector rotation with the economic cycle, the names in each group aren't a complete surprise. What Stovall found when he studied the way 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.)

|pagebreak|

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), and 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), and consumer staples and services (near the end of the stage) do well.

Look at Price-to-Earnings (P/E) Ratios

Those patterns are true only on average, though, 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, 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 ratios, because they are good indicators of investor sentiment, and analyst projections of future sector earnings, because they are good indicators 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, which will show how you can use it with that portfolio.)

A Closer Look at the Financial Sector

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

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

In the rally of 2009, as earnings recovered a bit, the rally took the sector up to a nosebleed P/E of 40.6.

That valuation isn't completely insane, because Wall Street analysts believe financial stocks will grow earnings per share by 141% in 2010. Remember, stock prices anticipate the future. That kind of growth 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 overoptimistic, 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 borrowed money 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."

Too Much of a Risk

On the downside, there's the very real possibility that analysts are wrong. Bank regulators for the Group of 20 (G20) 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, which could freeze parts 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. An example is 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), which has moved up in this rally to a P/E ratio of just 20.4. I say "just" because that's still significantly below the 2007 P/E ratio 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.

|pagebreak|

Looking at the Laggards

On the same basis, I'd call the consumer discretionary sector still decently valued, but 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 to bankruptcy, investors have been more hesitant than 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.

Any correction wouldn't be huge, so I'm willing to stick it out. But the uncertainty gives me a certain caution about moving quickly.

Time to Move the Money Around

Over the next few weeks, I'm going to take advantage of what 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 Exxon Mobil for a Devon Energy or a StatoilHydro, for example. (See my recent head-to-head blog post comparing Statoil with Brazil's Petrobras.) In other sectors, such as industrials, I'll continue to add to my exposure, as I have with the recent purchase of Johnson Controls (NYSE: JCI).

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

At the time of publication, Jim Jubak owned shares of the following companies mentioned in this column: Devon Energy, Johnson Controls, Petrobras, and StatoilHydro.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

Related Articles on STOCKS

Keyword Image
The Best Buys in Cybersecurity
12/08/2017 5:00 am EST

After weeks of sifting through hundreds of cybersecurity stocks on the market, I finally narrowed my...