Why Cyclicals Will Be Hot for Investors This Summer
Cyclicals are starting to look more attractive ahead of the summer months as the economy starts to show signs of improvement, according to analysts.
"There's been a lot of turbulence in the global markets, but the underlying bullish story is still intact," said Thomas Lee, chief U.S. strategist at JPMorgan. "There's a story of wealth effect helping the global consumer, particularly in the U.S., and U.S. housing continues to be strong. [Investors] are still underweight cyclical stocks, so the story of markets being driven by cyclicals is intact."
Attracted by higher dividends and amid skepticism over the economy's health, investors largely favored the safer, defensive sectors the first few months of the year. In the first quarter, health care, consumer staples and utilities were the top three S&P 500 sectors. And so far this month, materials, financials and energy have been the biggest laggards, while investors have been continuing to add positions in consumer staples and health care.
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Cyclical sectors are closely tied to economic performance, while defensive stocks (noncyclicals) traditionally outperform the market when economic growth slows or during downturns. Some strategists argue that it is harder for the market to sustain its gains when defensive names outperform as it usually signals economic weakness.
On Tuesday, all key S&P sectors retreated, with investors rattled after the Bank of Japan's latest monetary policy decision and on questions about when the Federal Reserve will slow its bond-buying program. Financials, energy and materials were the worst sector performers, each slumping over 1 percent.
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"There's still a risk aversion in the economy, and that's playing a big role," said Lee, regarding the stronger performance so far in the defensive sectors. "And until people feel there's a lot more evidence of stronger underlying economic growth—not just in the U.S., but globally—I think people do like that safety net. For now, we still have a market that people only reluctantly believe."
At the same time, Lee said he is betting on signs of "much better" global growth in the second half.
"Earlier this year, the outperformance of dividend stocks over cyclicals was extreme," Lee said. "One of the more important stories over the next five years is that if we're in a regime shift of rising rates and the U.S. economy strengthening, everyone's going to start focusing on cyclical profit growth, which will favor the cyclical stocks, so I think this may be the start of the shift."
Meanwhile, John Manley said the equity market's rotational pattern in the first four months followed the "classic bull market" stereotype and advised investors to rotate into the cyclical sector as the summer progresses.
"It begins with the Federal Reserve pushing liquidity into the economy to stimulate it. That liquidity flows through the capital markets on the way to the economy," explained Manley. "Before it has any effect on the economy, it tends to lift the early cycle sectors [utilities, staples, health care]. As it reaches the economy, traditionally, the consumer gets the first benefit and the consumer cyclicals sector rotates into favor."
While, markets have been volatile in recent weeks as talk grew louder that the Fed could start to scale back some of its $85 billion in bond purchases, Manley said that the central bank will likely keep rates low for "at least the next three to four quarters" and advised investors to use the "market disruptions" to add to positions.
"Later, industrials and information technology will benefit, as consumer demand begins to affect industrial production," he said. "Sometime after that, the late cycle commodity areas are traditionally the last to attain prominence."
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