Smackdown: Cyclical vs. Defensive Sectors

06/28/2013 7:00 am EST

Focus: ETFs

As it turned out, the most recent Great Sector Rotation was short-lived and perhaps not so great after all, writes Russ Koesterich on ETFdb.com.

Although defensive sectors are back to outperforming cyclical sectors amid June market volatility, I still believe there’s a strong case for preferring cyclicals over defensives, or at least select cyclicals.

There are three reasons to consider investing in cyclical sectors now.

  1. Attractive Valuations. Defensive sectors continue to look overpriced. Investors searching for safety and yield have driven up the valuations of defensive companies. The three classic defensive sectors—healthcare, staples, and utilities—are now trading at an average premium of around 20% to the broader market. By way of comparison, back in the fall of 2009, these three sectors were trading at an average discount of around 40% to the broader market. Current premiums seem unjustified considering that profitability is somewhat lower for companies in the defensive space.

  2. Exposure to Emerging Markets. Second, cyclical sectors, particularly technology and industrials, generally have more exposure to emerging market growth than their defensive counterparts. This means that they’re a good way to access my preference for emerging markets without actually investing directly in emerging markets themselves.

  3. Current Relative Risk Levels. Although cyclical sectors have always been, and probably always will be, more risky (as measured by realized volatility) than defensive sectors, there are fluctuations in cyclical sectors’ riskiness relative to their defensive counterparts. Currently this relative risk is low when compared with its average level over the last five years. This is partly because defensive sectors have become riskier as investors have flocked to them. As more crowded trades, defensive sectors are potentially more sensitive to investor sentiment and could experience greater price volatility.

However, not all cyclical sectors are created equal. Here’s a ranking of how I believe the various cyclical sectors stack up, from the most attractive to the most expensive.

Energy (most attractive)
Information Technology
Industrials
Consumer Discretionary
Financials
Materials (least attractive)

The list above is based on my team’s analysis of whether sector valuations appropriately price in each sector’s expected earnings growth, profitability, and risk.

Based on these factors, I have a preference for the energy and informational technology sectors, accessible through the iShares S&P Global Energy Sector Fund (IXC) and the iShares S&P Global Technology Sector Fund (IXN). If it turns out that we do see more investors rotating out of defensives and into more attractively priced cyclicals, these two sectors are poised to especially benefit.

Disclaimer: The author is long IXC

By Russ Koesterich, CFA, Contributor, ETFdb.com

Related Articles on ETFs

Keyword Image
The Omen
12/07/2017 10:50 am EST

The probability of an equity market correction over the next few months is slim to none, so there co...