Strategist Jim Paulsen: Here's what to own when yields are surging

Published Tue, Nov 15 201612:16 PM EST

Rotate out of "safe haven" assets and into commodity and industrial stocks, which do better historically during times of rising rates, according to Wells Capital Management chief strategist Jim Paulsen. "Because the character of this [economic] recovery is undergoing a transformation, investors should anticipate that leadership in the stock market will also probably be altered," Paulsen wrote in a research note Tuesday. In the past year, the strategist explains that investors have been fixated on a "risk-off" mentality, mainly sticking with large-cap, dividend-paying U.S. companies and other bond surrogates. But as the U.S. economy approaches near full employment and expectations of higher growth ahead are baked in, Paulsen thinks interest rates will likely trend higher and the Fed will be forced to end its accommodative policies — therefore driving a rotation into high-growth stocks. Since reaching a multiyear low in July, the yield on the 10-year U.S. Treasury note has spiked by nearly one full percentage point. Source: Wells Capital Management "In the balance of this recovery, we suspect leadership will shift toward international markets, toward small and mid-cap stocks and toward industrial/capital goods sectors," said Paulsen. As shown on the chart above, which shows the historical monthly excess returns from periods of rising yields minus periods of falling yields since 1960, the best sectors have been commodity and industrial sectors such as machinery, steel, mining and oil. Inversely, the worst performing areas of the market have been interest-rate sensitive areas such as utilities, financials, construction and consumer-related stocks such as food and retail, according to Wells. Among those neutral sectors, which seem to be invariant to the interest rate environment, such as cars, chemicals, durables, among others, Paulsen believes there's an opportunity for stock pickers to benefit from any mispricing due to the market's reaction to rising yields. "Investors should consider the factor and sector bets embedded in equity portfolios. Perhaps it is time to lighten up on low volatility and yield sensitivity and tilt toward higher beta, lower capitalization, greater price momentum and toward more industrial/capital goods sectors," he said.

The Empire State Building is seen hidden in the clouds as construction continues at the Hudson Yards project in New York City on October 1, 2016.

Bryan R. Smith | AFP | Getty Images

"Because the character of this [economic] recovery is undergoing a transformation, investors should anticipate that leadership in the stock market will also probably be altered," Paulsen wrote in a research note Tuesday.

In the past year, the strategist explains that investors have been fixated on a "risk-off" mentality, mainly sticking with large-cap, dividend-paying U.S. companies and other bond surrogates.

But as the U.S. economy approaches near full employment and expectations of higher growth ahead are baked in, Paulsen thinks interest rates will likely trend higher and the Fed will be forced to end its accommodative policies — therefore driving a rotation into high-growth stocks.

Since reaching a multiyear low in July, the yield on the 10-year U.S. Treasury note has spiked by nearly one full percentage point.