How to Invest in a Zigzag Economy I

How to Invest in a Zigzag Economy I

The US remains mired in the early stages of a recovery, while emerging markets are speeding into later stages. Knowing how to bridge the gap is key to picking stocks now.

Are you in the right sectors of the stock market for this point in the economic recovery? Solid data stretching back to 1945 show that certain industries and sectors outperform during specific stages of any economic recovery.

No argument from me on that. I think investors should do everything they can to put the power of the economic cycle behind their portfolios.

Just a couple questions, though: Where exactly are we in the economic cycle? And in the new global economy, does it still make sense to think about over- or underweighting sectors, just on the basis of where the US stands in the economic cycle?

My answers to those questions are complicated (and take up the rest of this column). The short response is that the US economy is in the early recovery stage of the economic cycle. That means you should be overweighting the sectors that do best in that stage: Basic materials, as well as industrials near the beginning of this stage and energy near the end.

But my best estimate is that the global economy is further along in the recovery cycle, and that this is especially true for emerging economies. I think the global economy has made the transition from early- to late-stage recovery. That means that for foreign stock holdings (and for US companies that rely on sales in the developing world for growth), you should be overweighting those sectors that do best in the late stage of the recovery cycle. Energy typically does well in this stage, and, near the end of the stage, consumer staples and services also tend to prosper.

Confused yet? Let me explain now in more depth and lay out a way for you to position your portfolio for this unique moment in the global economic cycle. I’ll end by suggesting a few stocks that I think fit our rather complicated picture.

A Primer on the Economic Cycle

The best work on this subject comes from Sam Stovall, the chief investment strategist for Standard & Poor's Equity Research. His 1996 book, Sector Investing, is still the best resource on the subject.

Stovall divides the economic cycle into four stages:

• Early recession: You should remember this stage vividly. Consumer sentiment ranges from fear to terror. Industrial production plunges, interest rates peak and then start to fall, and unemployment begins to rise rapidly. Sectors that have done well—relatively, at least—during this stage include services (near the beginning), utilities, and (near the end of the stage), cyclicals and transportation stocks.
• Full recession: Gross domestic product tumbles, interest rates keep falling, and unemployment rises. Sectors that do best during this stage historically have been cyclicals and transportion. Technology performs well at the beginning of the stage; industrials benefit near the end.
• Early recovery: Consumer sentiment improves, industrial production turns up, interest rates hit bottom, and unemployment peaks and starts to move lower. Sectors that do best are usually industrials (near the beginning of this stage), and basic materials and energy (near the end).
• Late recovery: Interest rates rise as the central bank tries to control inflation, consumer sentiment heads down, and industrial production is flat. Sectors that have done well in this stage include energy and, near the end of the stage, consumer staples and services.

In 2009, it seemed we were well along the path to recovery. The economy had bottomed in the second quarter with US GDP contracting by 0.7%. The economy then grew by 1.6% in the third quarter and by a huge 5% in the fourth quarter.

The recovery was off and running. In January 2010, I wrote that we were in the early recovery stage of the economic cycle.

And then the economy double-crossed us. In 2010, GDP growth dropped to 3.7% in the first quarter and to 1.7% in the second quarter.

1.7%? Wasn’t that just about the 1.6% growth investors had seen back in the third quarter of 2009?

No wonder lots of economists and investors started to worry that we were headed to a double-dip recession—and that the next quarter would show a drop back to something like the negative 0.7% growth of the second quarter of 2009. But luckily, the economy decided that it had at least one more zigzag up its sleeve. Economic growth accelerated to 2.6% in the third quarter of 2010 and now economists are expecting 3.5% growth for the fourth quarter of 2010.

Déjà Vu All Over Again

As of this January, in my opinion, the United States is back in or still in (take your pick) the early recovery stage, and a little bit further along the way from early recovery to late recovery. In the past calendar year, I think we’ve traveled the equivalent of what would take maybe three to four months in a typical economic cycle. At this rate, I don’t think we’ll enter the late recovery stage until the end of 2011 or so.

Emerging economies are further along. Since they rebounded more quickly from the global economic crisis, they’ve moved faster through the economic cycle and are now approaching late-stage recovery.

moneyshow.com