It's hard to believe, but this week marks the end of the second year of the bull market, and the beginning of the third. Though opinions vary about how much - if any - bull market is left to go, there are few arguments against the idea that we're closer to the end of this cyclical bull than the beginning of it.
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That's not designed to be a clarion call for the bears, and certainly not intended to mean the next cyclical bear is already here. It is, however, a strong recommendation that we start thinking about how we need to rework our portfolios to achieve maximum performance for the next stage of the cycle.
If you're an ETF investor, then this model should be ultra-easy to embrace. Even if you dabble in stocks though, these ideas are easy enough to implement via equities; we're simply using exchange-traded funds as a proxy. Just for quick reference, here are the cycle sequences for all three models.
|Leading Sectors at Different Stages of the Econ/Market Cycle|
|Market Stage||Economic Stage||John Murphy||S&P||?|
|Early Expansion||Basic Materials||Technology|
|Middle Bull||Capital Goods||Capital Goods|
|Late Bull||Mid-Recovery||Basic Materials||Energy||Basic Industries|
|Early Bear||Peak||Energy||Health Care||Energy|
Assuming the economy is in the mid-recovery stage and that the market is in a late bull-stage (and even post-peak periods), two arenas are must-haves. The first one is basic materials, according to John Murphy's model, and the other is energy, according to the Standard & Poor's model. The iShares Basic Materials Sector Fund (NYSE:IYM) and the iShares Dow Jones US Energy Fund (NYSE:IYE) would fit the bill quite nicely, though investors may want to pick their own individual stocks.
To answer the next question, yes, energy stocks have already been on fire since September of last year. There's no cap on how far they can continue to climb though. As for basic materials stocks, even with the help of precious metals they've been only a little better than mediocre over the last year or so.
All that being said, one has to wonder how far into the late-bull stage we really are, given what we're seeing on the oil front.
What's Not Hot
Again, assuming we're now past the mid-bull and early expansion periods, both the Murphy and S&P models say that capital goods stocks' best days are behind them. That's still a bit of an ambiguous sector, but it doesn't exactly bode well for the Consumer Discretionary Sector SPDR (NYSE:XLY), nor the iShares Industrial Sector Fund (NYSE:IYJ).
Interestingly, both had been solid leaders up until the end of last year. Almost as if on cue though, both ETFs started to weaken as we entered 2011, dovetailing right into the rotation model.
The tricky part about sequence-based models is that it's never clear how long one stage will last or when the next one will begin. In other words, though it may be time to step into materials and energy (if you haven't yet), how does one know when the economy is at its peak and we're in the middle of a bear market?
At the risk of sounding flippant, we'll know it when we see it. Either way though, we need to be ready to migrate into consumer staples and then utilities as we're knee deep in a bear market. Somewhere along the way Standard and Poor's suggests some healthcare exposure as well. Those areas can be covered by a combination of the iShares Dow Jones US Utilities Fund (NYSE:IDU), the iShares Dow Jones US Healthcare Fund (NYSE:IYH), and the iShares Dow Jones US Consumer Goods Fund (NYSE:IYK), though again, a related individual stock may bear even more fruit.
Yes, the utilities sector, the healthcare sector and the consumer staples sector (along with the financials) have been the absolute worst-performing groups over the last twelve months. Each of them, in fact, is underwater compared to where they were a year ago. So why would anybody want them now? That's the whole point of the sector rotation analysis. What leads will eventually lag, and what lags will eventually lead. The models simply tell you when to get off and on the next likely leader.
Keep the Bigger Picture in Mind
The market's day-to-day noise may overshadow these longer-term trends most of the time, so it's up to the individual investor to make sure he or she keeps tabs on how these sector trends - and the underlying cycle - are taking shape. Far more often than not though, it's worth the trouble simply because the models are accurate. (For related reading, also take a look at ETFs For Sector Rotation Strategies.)Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!
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