Quarterly Investment Guide

Cyclical stocks may finally be ready to cycle higher

Bryan Borzykowski, special to CNBC.com

The industries that historically do well in an improving U.S. economic environment — cyclicals — have underperformed this year. But some experts are hopeful that recent gains for cyclical stocks suggest momentum may stay with them. As some surprising equity market leaders hit the wall, cyclical stocks could be a key for investors looking to ride the bull market a little longer.

"Everyone has been scratching their heads as to why the traditional sectors are not reacting quite the way they should have yet," said Ryan Larson, RBC Global Asset Management's head of equity trading for the U.S.

The S&P 500 gained 0.77 percent in the first quarter. Yet the cyclical stocks that should be outperforming the average are struggling to keep pace. Since the start of the year, financials have fallen by 5 percent, while consumer discretionary is up by 1 percent.

Meanwhile, high-yielding, more defensive sectors, have led the way. Telecom is up 8.7 percent since the year began, utilities by 14 percent and consumer staples close to 6 percent.

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Usually, when an economy is growing, sectors like financials and consumer discretionary — areas that benefit from improving conditions — do well. Defensive sectors, such as telecoms and consumer staples, take a backseat. In a rising rate environment, utilities and REITs, both interest-rate-sensitive industries, should also see declines.

That's why traders and financial advisors are looking closely at a few signs of change in March.

Consumer discretionary stocks were up near 6 percent in March, and financials were up near 7 percent. Technology, another cyclical play, was up 8 percent in March.

Everyone has been scratching their heads as to why the traditional sectors are not reacting quite the way they should have yet.
Ryan Larson
RBC Global Asset Management's head of equity trading for the U.S.

Now is the time to increase at least some of a stock allocation to more risk-on industries, said Sam Stovall, a U.S. equity strategist with S&P Global Market Intelligence. And he is seeing more people buy companies with lower S&P ratings, which indicates higher risk but potentially more reward. "People are thinking that maybe the coast is clear once again," Stovall said.

One advantage to adding cyclical stocks is that these sectors are less expensive on a price-to-earnings ratio basis than the higher-yielding defensive stocks, which have been run up in price. "[Defensives] are trading at a 10 percent-plus premium to their relative P/Es over the last 20 years," Stovall said.

"There are some very good opportunities in these (cyclical) sectors," Larson said. "People's fears were way overdone."

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Dryden Pence, co-founder of Newport Beach's Pence Wealth Management, said his firm is shifting more of its clients' assets into cyclical sectors. "People are making more money than ever before," he said, which means an increasing number of Americans will start buying more goods and services. "The second-largest economy in the world isn't China," he said. "It's the U.S. consumer."

Pence said investors are very impatient, but they are getting more comfortable with owning riskier assets. "What we forget is that bad news happens fast and good news takes a while. So we had some bad news in the rise of the dollar and lower oil prices, and it takes a while for those things to work their way through the economy. But we're starting to see good things happen now," Pence said.

While that bodes well for technology and consumer discretionary, two of the strongest cyclical plays in March, nearly all cyclicals have reversed their start-of-the-year stall out.

Energy, the best-performing sector in March, was up 9 percent; both materials and industrials climbed by 7 percent. Of course, it helps that the S&P 500 itself was up 6 percent in March, posting its best single-month run since 2009.

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"The market may have effectively been pricing in a U.S. recession earlier in the year," said Andrew Lee, a managing director in the chief investment office at UBS Wealth Management. "Perceptions have reversed a bit."

With bond yields still at historically low levels, investors won't want to dump their dividend-paying stocks — it's still the only way to get regular income. But investors could trade out some of the more expensive payers for cheaper and faster-growing cyclicals.

It's unlikely the gains will be achieved in a straight line, which is why it's important to have a mix of defensive and cyclical equities. Volatility is here to stay, Larson said, so the more stable sectors will likely see more gains when markets get jittery.

That said, these experts do think that fears have subsided enough that cyclicals will see a bigger jump through the second quarter.

By Bryan Borzykowski, special to CNBC.com