Cyclicals stocks have outperformed defensives in recent weeks as investors bet the U.S. economy is on firmer footing. Next week could be a test. Investors face a slew of economic reports culminating with the May jobs report next Friday.
Over the past month, cyclicals led by the financials sector have outperformed defensives like telecoms and utilities as well as the broader market.
"We're encouraged to see cyclicals outperform, which is what you see in an improving economic environment," Westwood Funds' David Spika said.
The financials and industrials sectors gained 6 percent and 5 percent, respectively, in May while the utilities, telecoms and consumer staples sectors all posted steep losses. The S&P 500 gained just 2 percent, after logging a 1 percent drop on the final trading day of the month.
Traders suggested that the "Hindenburg Omen," an ominous technical sign that seems to pop up every few years and can signal a major market tumble, was at play in the late-day selloff on Friday. The MSCI indices, widely followed benchmarks, were also rebalanced which may have led to some portfolio repositioning heading into the close.
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"The market can continue to go down a little bit here, but we're looking for select opportunities," Eric Green of Penn Capital Management said. "We think cyclicals leading this market over the last month and some of the real defensive names where money is starting to come out of indicates the economy is getting better."
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A number of equity strategists are also advocating investors take a cyclical tilt in their portfolios.
"We continue to prefer inexpensive cyclical sectors that have cleaned up their balance sheets, have the ability to grow dividends and have exhibited a surprising level of earnings stability over the last cycle," Bank of America Merrill Lynch strategists wrote. "And we remain underweight expensive, low beta, high dividend yielding sectors—namely utilities and telecom."
Vadim Zlotnikov of AllianceBernstein also leans toward cyclical areas of the market. In addition to continuing to play a housing market recovery, Zlotnikov, said, "Parts of technology, particularly communication equipment, continue to run." He also said to look at areas of the market that benefit significantly from rising interest rates like the life insurers.
Jobs, Jobs, Jobs
Good economic data should continue to support cyclical stocks. And the market will have plenty of it to pour over to help better determine just how strong the U.S. economy is.
The jobs data is paramount, given the Federal Reserve's insistence that strength in the labor market, along with inflation, will help determine when it starts to pare back its bond purchases.
Jeffrey Cleveland, senior economist at Payden & Rygel, noted in an email that the jobs report "trumps all else, in my view, due to the market's fixation on the 'flow' of Fed purchases and possible 'tapering.' Although throughout the week the market will ebb and flow with the jobs-related data" like the ADP employment report, the ISM surveys and weekly jobless claims.
Eric Rosengren, president of the Federal Reserve Bank of Boston, said on Wednesday, "the Fed should continue the purchase program until we see more sustained improvement in labor markets and have greater confidence that the economic recovery is sufficiently self-sustaining to yield continued progress in reducing the still very high unemployment rate."
Economists polled by Reuters forecast the economy created 160,000 nonfarm payroll jobs in May, a bit softer than the 165,000 created in April. But the unemployment rate is seen holding steady at 7.5 percent.
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That could keep the Fed from tapering this year, some economists say. Jerry Webman, Oppenheimer Funds' chief economist, said that it would take a series of reports showing more than 200,000 new jobs before the Fed starts to reduce its quantitative easing program.
Economists at Bank of America Merrill Lynch agree. "QE tapering is possible this year, but it would probably require sustained 200,000 gains in payroll employment and commensurate strength in other growth indicators, along with higher inflation," they wrote in a research note. "We continue to expect none of the above."
"If it's a weak (jobs) number I think you're going to see a selloff and I think it will be met with buying," David Seaburg, of Cowen & Co., said. "Pullbacks are a buying opportunity and you need to take advantage of it."
He added, "the cyclical rally is on."
The other major economic reports the market will be watching include the ISM manufacturing report for May, construction spending, April international trade, the May ISM services index and April factory orders.
The ISM manufacturing index for May is forecast to soften slightly to 50.5 from 50.7, according to estimates from Reuters. Construction spending for April should increase 1 percent after a 1.7 percent decline in March.
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Economists are expecting the April trade deficit to widen to $41 billion from $38.8 billion when the data are released on Tuesday.
On Wednesday, the ISM services index should show modest improvement with a reading of 53.3 in May, up from 53.1 the month before. Factory orders are also expected to rise 1.5 percent for April after a 4.9 percent drop in March.
Auto Sales Should Show Zip
The automakers will also be releasing their May sales figures on Monday, with estimates calling for total vehicle sales to rise to a 15.1 million annual rate from a 14.9 million annual rate.
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"This is the time of year when the automotive industry holds its collective breath as the recent past has dealt with a spring slowdown in demand; however, the current pace suggests full steam ahead for the second half of 2013," said Jeff Schuster, senior vice president of forecasting at LMC Automotive, in a release. "Economic and market headwinds have been minimized, while demand continues to build momentum."
The auto stocks have already responded, with General Motors and Ford up 11 percent and 16 percent, respectively, over the past month—further evidence of the growing shift into cyclical stocks as investors position for better economic growth ahead.
"The numbers are continuing to get better," Chase Wealth Management's Anthony Chan said. "Car sales are strong. Consumer confidence is at five-year highs. This is all telling me that consumers would not be this excited unless labor market conditions are improving."
Markets will see how much things really have improved come next Friday.