While I forever preach the folly of market timing---having just finished a fairly involved research/due diligence session---I thought I might give you a little insight into my world as a way of illustrating why I preach what I preach.
The following is, in a tiny nutshell, a behind the scenes look at why a forward-thinking investor might like (in order of magnitude of like) the materials, energy, technology, financial and industrial sectors going forward. And shun (in no particular order) the discretionary, staples, utilities and healthcare sectors:
The economy is cyclical. It meanders its way through contractions and expansions and back again. I'll simplify (very much so) matters here and break the business cycle into four phases:
The early-cycle phase is generally characterized by a substantial pick up in economic activity, growing credit, and accelerating corporate profits. Monetary policy is very accommodative. The top four performing sectors are typically consumer discretionary, materials, industrials and technology.
The mid-cycle phase, typically the longest phase, sees continued credit and profit growth. Monetary policy is generally accommodative, but not to the early-phase extent. Inventories tend to catch up to sales growth (versus low inventories in the early phase). The top four performing sectors are typically technology, energy, industrials, and health care.
The late-cycle phase sees slowing economic growth, tightening credit conditions and contracting profit margins. Monetary policy is restrictive. Momentum in inventory growth can continue while sales growth contracts. The top four performing sectors are typically energy, materials, healthcare and consumer staples.
The recession phase is characterized by slumping economic activity. Credit evaporates and corporate profits contract. Monetary policy becomes accommodative. Inventories decline despite falling sales. The top four performing sectors are typically consumer staples, utilities, telecom and healthcare.
Now, one might think that it shouldn't be all that hard---with history as our guide---to know (approximately) which phase of the cycle we're in at any given time, and, thus, how to rotate among sectors accordingly. Well, one might think that, but one shouldn't.
Take, for example, the monetary policy piece. On average, the early phase lasts around 15 months, the mid phase goes for about 4 years, and the late phase tends to go about 18 months. But we're almost five years removed from the last recession and monetary policy is, well, accommodative doesn't even begin to describe how accommodative monetary policy is. If the Fed has it right, we are smack dab in the middle (or maybe the latter) of the granddaddy of all early phases. However, sector performance (at least on a year-to-date basis) doesn't entirely jibe with early-phase history. Materials is supposed to be one of the best performers, but it's 3rd from the bottom. Technology doesn't come close either. However, consumer discretionary and industrials are among the top 4 performing sectors.
Well, I guess 50% ain't all that bad. So, for the sake of this paragraph, let's say we are indeed in the midst of what has to be history's longest early phase. Of course now, after nearly 5 years, we better start thinking mid-phase. Which means our bias going forward should be toward technology, energy, industrials and health care.
But what about valuations? You see, health care has been on a tear of late, and, from a forward price to earnings (p/e) standpoint it's the second most expensive sector. Plus, you'd think, based on health care's performance, we're at least at the end of the mid phase, if not well into the final stretch. And if we're that far down the road, we should be buying more consumer staples, but that's the third most expensive sector. Now, materials look reasonably priced, but if the Fed's right it'll be one of the worst performers for awhile yet. Dang!
Believe me, I can go on and on in this vein, and throw in all manner of nuance, for pages, but I won't. I'll just cut to the chase and share my findings:
For starters, I'm making a guess (a GUESS!) that we're well within mid-cycle. Which suggests that at some point in the not too distant future, we should be looking to rotate out of consumer discretionary, telecom and technology, and into energy, materials, health care and consumer staples. However, when I consider valuations, which I always strongly consider, I do not want to be buying health care and consumer staples anytime soon (unless, maybe, they first take a monster hit), and financials and technology look very attractive to me.
Again, tech looks good, valuationally-speaking, but not (perhaps) cyclically-speaking; I might---my cycle guess notwithstanding---add a little exposure to underweighted portfolios. Same for financials (potential interest rate sensitivity notwithstanding). Staples make cyclical sense, but too expensive to add exposure; I would reduce exposure in overweighted portfolios, but---valuation notwithstanding---I would maintain a reasonable allocation at all times in this economically-defensive sector. Same for health care. Consumer discretionary has been phenomenal of late and, thus, currently has the loftiest valuation, I would not add, and possibly reduce (depending on present position) exposure (but I'd still maintain some exposure to this economically-sensitive sector). Industrials look attractive to me, and I'm willing to increase exposure in under-weighted portfolios, despite where we might be in the cycle. Energy---valuationally and cyclically---is a buy for underweighted portfolios. Same for materials. I would maintain an underweight position in utilities. Same for telecom. You got all that?
So, what should you take away from all that. For starters, if you're our client, consider it a sneak preview of the rambling session you'll suffer through at our next review meeting. For everyone else, may it serve as yet another confirmation that there is no knowing anything for sure when it comes to the financial markets and the economy, regardless of what those whom you watch on CNBC, or whose how-to-invest books you may read, would have you believe. If they truly knew what they'd have you think they know, they'd have no need to promote their methods, or tout their holdings.
Yes, business cycle and valuation-based sector rotation is a worthy undertaking, but only while maintaining a broadly diversified mix among most, if not all, sectors (notice I'm still maintaining some exposure to my currently least favorite sectors), as well as among market caps (small, mid and large cap stocks) and international equities.