Playing the Sector Rotation Game

10/05/2010 11:47 am EST

Focus: ETFS

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

Benjamin Shepherd, associate editor of Personal Finance, says investors should follow the business cycle, and he tells where he thinks we are now.

The average US business cycle encompasses 60 months of expansion and ten months of recession—a fairly forgiving time [period].

According to the National Bureau of Economic Research, the business cycle involves five distinct phases: three expansionary stages and two recessionary periods. Different sectors tend to outperform in each stage.

In the initial expansionary stage, businesses ramp up to fulfill new orders—a boon for technology and transportation stocks. During the next phase, basic materials, industrials, and personal and business services benefit from increasing corporate outlays and flush consumers.

Consumer staples and energy are your best bets in the third expansionary stage. Although lumpy economic data has many investors in a lather, the US markets appear to be somewhere between the first and second expansionary stages. Technology and transportation are beginning to yield their market leadership to materials and industrials.

[But] the sector has plenty of room to run. Corporate spending on information technology remains robust, while consumers continue to buy smart phones at a rapid clip.

Nevertheless, despite one of the strongest PC cycles in years, prominent names such as Intel (Nasdaq: INTC) and Microsoft (Nasdaq: MSFT) continue to trade at historically low valuations. Overall, earnings in the technology space are expected to increase 45% in 2010 and 14% in 2011. With a price-to-earnings ratio of just 13.5x, the sector abounds with bargains.

A recent up tick in mergers and acquisitions—Intel’s purchase of McAfee (NYSE: MFE) and the bidding war between Dell (Nasdaq: Dell) and Hewlett Packard (NYSE: HPQ) for 3PAR (NYSE: PAR)—likewise makes the sector attractive.

iShares S&P Global Technology (NYSEArca: IXN) is heavily weighted toward domestic names, which account for roughly three-quarters of the fund’s portfolio. Its foreign exposure includes shares of top-notch firms such as Taiwan Semiconductor (Taiwan: 2380, NYSE: TSM) and SAP (Germany: SAP, NYSE: SAP). Buy IXN up to $55. (It closed just below that price Monday—Editor.)

iShares S&P Global Materials (NYSEArca: MXI) tracks an index that consists primarily of large-cap global materials firms that continue to benefit from robust economic growth in China and other emerging markets.

Its top holdings read like a who’s who of mining giants: Stakes in Rio Tinto (ASX: RIO, NYSE: RTP), Vale (Brazil: VALE3, NYSE: VALE) and BHP Billiton (NYSE: BHP) account for more than 20% of the portfolio. Such concentration has its risks, but these behemoths have unbeatable reserves and low-cost operations.

Share prices have fluctuated because of concerns about China’s slowing economy, but the Chinese government is committed to sustainable growth. Expect the country’s demand for raw materials to remain robust.

In [looking at] the business cycle, now is the time to buy materials stocks. As an added bonus these investments also provide a hedge against a weak US dollar. MXI rates a Buy up to $65. (It closed above $63 Monday—Editor.)

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