3 Sectors to Move Into as Bull Matures

06/17/2011 2:00 pm EST

Focus: STOCKS

James Stack

President, Stack Financial Management

Knowing which stocks perform well even through a bear market can help you hunt for values before the markets top, says Jim Stack of InvesTech Research in this exclusive interview with MoneyShow.com.

You've done such a great job since your market call in 2009, one month before the absolute market bottom. What was it, the "investment opportunity of a lifetime?"

We said we were approaching the "buying opportunity of a lifetime." Even then, I don't think we realized how important that bottom would be in March 2009.

But that came after several career smackdowns that you did as a market-call guru. There were the ones in the late '90s, there was the tech bubble bursting, and then that one you always put up with the homebuilding index, tracing what we had just experienced.

Our housing bubble index that we developed in 2005, which said this is not going to end nicely.

Then it ended up tracing out almost identically.

Yeah, it basically forecasted what we were going to see in the housing market. So it proved very helpful to us and our subscribers and clients in avoiding the washout in the housing sector and the banking sector.

If you avoid those high-risk areas of the market in different market cycles, if you know where the highest risk is and you can avoid those, then you're going to end up with safer returns.

That's exactly what I want to talk about. What I'd like to focus on are those sectors, because we talked about staying in the right sectors, but also using sector investing—not only to maximize returns, but to increase your defensive position, knowing which sectors are going to perform best in the next downturn.

Could you help us with how that works, and where we are now?

It's important to recognize that sector management in your portfolio is an important fundamental of risk management. It's how you help improve your performance in a bull market while reducing the risk in a bear market.

Now I'm not talking about making big sector bets. You never go out and put more than 15% or 20% of your portfolio in any sector.

But recognizing which sectors are the early bull market sectors…those that perform the strongest are typically the financials, the consumer-discretionary stocks like restaurants and hotels, and also the technology stocks. Those are the strongest early performers in a bull market.

As a bull market ages, then the other sectors kick in.

Is that where we are now?

Yes, we're in a maturing bull market, most likely in the second half, although we don't see any warning flags of the end yet. But other sectors take over: energy, industrials, and materials.

As you get closer to the end of a bull market, and as...those warning flags start to appear, you steer toward the more defensive sectors.

Today I think one of the best-value sectors out there is one of those defensive sectors that holds up better in bear markets, and that's the health care sector. It's not one of the most popular on Wall Street, but trust me it will be popular in the next bear market, because it's going to be holding up the best.

Like pharmaceutical value tracks, right?

Yeah. In addition, you can go beyond health care. Utilities—I'm not a big fan of utilities. I know they're more defensive. Again look at those stocks in those sectors.

Another one is the staples; those things that people have to buy. Even Pepsi (PEP) and Coca-Cola (KO) today are more or less consumer staples, because people are going to buy them whether you're going into a recession or not.

If you look for those kinds of sectors and those kinds of stocks, when you get to the latter half or the latter third of a bull market, you're going to make your portfolio much more defensive and more impervious to risk. It doesn't mean you're not going to lose any money in a bear market, but you're going to lose a lot less than most people do.

Do any of those sectors stand out—for example, within the healthcare sector or the sub-sectors? I just joked about how sleepy and underperforming pharmaceutical stocks have been. The biotech side has started to show some real signs of vitality. So do you work the sub-sectors with ETFs?

We look at sub-sectors, but we like owning individual companies. I want to own the company based on its revenue flow, based on its balance sheet, and based on its valuation.

So you're not using many ETFs or funds?

Well, we generally try to steer away from ETFs. When you buy an ETF, you're getting the bad stocks along with the good ones. They're not focused only on the good stocks.

In our portfolio management, we manage almost $700 million today. We focus primarily—almost entirely—on individual stocks, as if we are going to buy the whole company itself, because:

  • I want to know what that balance sheet has in it;
  • I want to know if that company might fall off a cliff because of debt load;
  • and I want to know if those revenues that are coming in are likely to continue over the next five to ten years.

The sectors that we should be reducing positions in today?

If you still hold financials, I'd reduce financials. Also consumer discretionary, you know the restaurants and those things the consumer doesn't have to buy.

Hotels and real estate?

Yeah, well real estate I think is still going to stumble through a number of tough years. It's bottoming, but we're not going to see a significant upturn until at least 2013 or 2014. But again, that's where I would reduce if I were looking for a way to increase sector exposure, probably into healthcare and consumer staples.

If energy comes down, if oil comes back to $80 or $85 a barrel, I'd go out and do some bargain hunting in there, too.

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