The Time For Cyclical Stocks Is Now

By Aaron Levitt | November 25, 2013 AAA

While it’s taken us roughly five years to get here, the global economy seems to be finally firing on all cylinders. Unemployment rolls are dropping, GDP growth is returning to struggling Europe and critical emerging markets- like China- are once again realizing production gains. All in all, that’s sent the SPDR Dow Jones Industrial Average (NYSE:DIA) to record highs.

As we’ve moved passed the recovery phase of the business cycle, the time to bet on more “economically sensitive” stocks could be at hand. For investors, the cyclical stocks could prove to be the best buys in the upcoming year.

Best Earnings Growth In The S&P 500

Cyclical stocks are technically defined as those companies whose fortunes are closely tied to a booming economy. These include basic materials, technology and industrial firms and they will often see revenues rise when the economy is really cooking. Given the bullish prospects of 2014, they could just be the superstars of next year.

According to analysts at S&P Capital IQ, recent bullish factors will help drive the cyclicals higher in the months ahead. In the U.S., the housing market continues to improve as both pending home sales as well as new housing starts have been increasing over the last year. At the same time, the hydraulic fracturing boom has sent energy prices into the basement, benefiting both retail and industrial consumers of energy. Corporate technology spending has also improved as sales of productivity software and new devices have climbed.

Across the pond in Europe, economic growth has also returned- with many nations in the struggling Eurozone having moved out of recession. The continents debt woes have also quitted down in recent months. Likewise, Japan’s efforts to stimulate its stagnant economy have begun to bear fruit and many emerging markets are still producing swift GDP growth.

All in all, these factor should help propel earnings and stock valuations for the cyclicals.

Capital IQ predicts that earnings per share for the cyclicals in the S&P 500 should grow by 10.6% in 2014. That’s up from just 5.6% earnings growth this year. Already, the analysts’ predictions seem to be coming true. The various cyclical sectors have beat earnings forecasts by a wider margin than the broader index. Meanwhile, defensive sectors like utilities and consumer staples have failed to impress.

According, to Capital IQ, the projected earnings growth has the cyclicals are trading at a P/E of just 14.9. Making them “reasonably priced” and set for growth.

Playing The Cyclical Shift

Given that we’ve now moved into an economic expansion, the time to bet heavily on the cyclicals could be now. That means overweighting the industrials, materials and consumer discretionary sectors is order.

It stands to reason that manufacturing will continue to rise as the economy expands. Already, many industrial firms like Rockwell Automation Inc. (NYSE:ROK) and Emerson Electric (NYSE:EMR) have recently been reporting more mega-contracts for their products. ROK alone sees the energy boom adding roughly $100 million to its sales next year. All of this improved activity could make the iShares U.S. Industrials ETF (NYSE:IYJ) a major buy. The ETF tracks 223 different economically sensitive firms- including EMR, ROK and stalwarts like General Electric (NYSE:GE). All for just 0.45% in expenses.

Led by gains at Under Armor (NYSE:UA) and coffee purveyor Starbucks (Nasdaq: SBUX), consumer discretionary stocks are set to see a big 10.2% gain in earnings growth in 2013. As consumers open their wallets towards items that they “want” instead of “need”, the Consumer Discretionary Select Sector SPDR (NYSE:XLY) could be a huge winner. While the ETF isn’t cheap on a P/E basis, the fund should keep rising as the economy keeps expanding.

Finally, fueling an economic expansion falls to the basic materials companies. Everything from oil and natural gas to copper and steel will be in greater demand as GDP keeps going. Meanwhile, Capital IQ’s data shows that both energy and materials names are some of the cheapest sectors in the S&P- giving investors the best “bargains”. Pairing the ultra-cheap expense ratios (0.14%) of the Vanguard Energy ETF (NYSE:VDE) and Vanguard Materials ETF (NYSE:VAW) gives investors plenty of exposure to both sectors- currently 298 different stocks.

The Bottom Line

Its official, the data is pointing towards the next phase of the business cycle- economic expansion. That means, it’s time for investors to load up on cyclical stocks. As these firms profit from the expanding economy, portfolios should benefit as well. The previous picks in the materials, consumer and industrial sectors make a great way to overweight the cyclicals.

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