Running with the Bulls

U.S. soldiers have beaten back a rogue army. The economy is slipping into recession and consumers are growing anxious. The stock market has been struggling for several quarters. President Bush is tinkering with the tax code and hoping for an economic recovery. The year is 1990.

That bleak period was followed by a strong rebound in the stock market: the S&P 500, which fell by nearly 20 percent in a three-month span in the summer of 1990, went on to rise 350 percent during the remainder of the decade.

If you believe that a similar rebound is looming — or even a smaller one — it's time to move your clients into sectors that perform well coming out of recession. Prime examples are cyclical stocks and growth sectors, such as consumer discretionary stocks. And think small: Small caps tend to outperform as the economy rebounds, according to portfolio managers and market strategists. Also, stop thinking defensively. In times of economic growth, defensive sectors such as health care, utilities and consumer staples tend to lag.

If the most recent recession is any guide, the consumer discretionary sector could get a nice pop. The sector rose 39 percent in the six months following the market bottom of 1990. In that time, the S&P returned a more tame 27.8 percent.

Consumer discretionary businesses typically offer such non-essential services as entertainment, lodging and dining. Media companies, including Viacom and AOL Time Warner, retailers such as Best Buy and Bed Bath & Beyond, and toy makers including Mattel and Hasbro, also fall into the consumer discretionary category.

Many members of this sector were particularly hard hit as a result of the events of September 11. As the fear of further terrorist activity abates and investors return to normal routines, stocks such as The Walt Disney Co. should rebound, says Joe Battapaglia, market strategist for Gruntal. Disney has fallen more than 50 percent in the last 18 months. “Travel and tourism have suffered the most,” says Battapaglia. However, that could result in accelerating demand through 2002, he says.

Hot and cold

In search of value, money managers are revisiting other beaten-down stock sectors. Fleet Asset Management's Bob Armknecht, who oversees the firm's Galaxy Equity growth fund, is loading up on shares in the natural gas sector. Natural gas, he says, is increasingly the fuel of choice for both industry and consumers. “When economic activity hots up,” Armknecht says, “energy stocks lead the way. Cold weather should refocus attention [on energy], and the Middle East is always a wild card.”

Though Armknecht declined to discuss his current buying habits, his fund recently held large stakes in Williams Cos. and El Paso Corp.

The trouble, market gurus say, is that investing can be a zero-sum game: When the money flows into one sector, it's leaving another. Specifically, when the economy rebounds, investors abandon defensive names in search of fatter returns in sexier, high-growth sectors. That puts downward pressure on consumer staples, health care or utilities — where investors often hide during recessions.

“Investors typically rotate out of companies, such as Merck, Pfizer, Pepsi or Philip Morris, as they offer lesser [profit] growth in the near-term,” says Matt Brown, vice president of equity management at Wilmington Trust. By December, Gruntal's Battapaglia was warning that the consumer staples sector was already vulnerable to profit-taking after outperforming the S&P 500 by 36 percent over the 18 months ended Dec. 1.

While electronics (such as semiconductors; see chart) have enjoyed excellent historical returns coming out of recessions, some strategists say investors should underweight tech stocks this go-round. That's because the profitability of tech companies will continue to be under pressure; the industry still suffers from overcapacity and weak demand. What's more, tech stocks were quick to rebound following the market plunge after the terrorist attacks.

Morgan Stanley's new chief strategist, Steve Galbraith, points out that the tech sector rose by a very healthy 37 percent in the first two months of the fourth quarter. And the tech sector may look a little healthier in 2002 compared to an abysmal 2001, but “don't expect the kind of snapback [in product demand] we got accustomed to in the '90s,” says Merrill Lynch Tech Strategist Steve Milunovich in a note to clients.

Obviously, choosing the right sector is only part of the battle. You need to pick the right stocks, too. In the early phases of an economic recovery, it's best to stick with industry leaders. Investors first flock back to the most popular names, as they often offer greater earnings visibility as the strength of the recovery grows. “The industry leader in a category will resume its leadership role,” says Battapaglia.

However, as the economic recovery begins to mature, a buying opportunity is created for the second- and third-tier names in an industry. “When the economy is fully back on track, investors get a better sense that these secondary and tertiary names will not only survive but prosper,” says Fleet's Armknecht. Both strategists cite a similar example: Acquire Intel now and AMD later.

If a client has the risk tolerance for small caps, this is an excellent entry point, many pros say. Small-cap stocks have tended to do well after market bottoms. Mike Byrum, a portfolio manager with the Rydex fund family of Baltimore, Md., notes that the Russell 2000 index, a small-cap benchmark, surged 48 percent in six months after the market bottomed out on Aug. 31, 1982, while the Standard & Poor's 500 was up 27 percent. After the October 1990 market bottom, the Russell 2000 rose nearly 44 percent, while the S&P 500 was up about 26 percent.

Small stocks tend to rebound faster than large caps when the economy turns around because they are more economically sensitive. Prudential Securities Small-Cap Strategist Steve DeSanctis says that small caps boosted profits at a faster clip than their large-cap brethren for eight straight quarters coming out of the last recession. Besides, small caps are inexpensive on a relative P/E basis compared to large caps. This is so despite the greater earnings leverage in an economic rebound. “We think that's out of whack,” says Brown at Wilmington Trust.

Everybody knows that trying to time the market, much less predict economic turning points, is notoriously difficult. So, “the prudent investor can use some of both strategies,” says Raymond James Chief Investment Officer David Henwood, “balancing a defensive near-term strategy with periodic purchases of leading companies that may be in the last few quarters of economic weakness.”

Bullish Behavior

Average performance of S&P groups three years after start of recession-ending rally