On Second Thought ... Maybe Fed Tapering Won't Be So Bad

Traders work on the floor of the New York Stock Exchange (NYSE) in New York City.
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Traders work on the floor of the New York Stock Exchange (NYSE) in New York City.

Wall Street came back from the long weekend with a rosier view about possible tapering by the Federal Reserve. The Fed's eventual throttling back on the liquidity injections might indicate a much stronger economy—and that could be good for cyclical stocks, according to strategists.

Although markets last week fell on concerns that the Fed may soon start curtailing its bond purchases as economic conditions warrant, many do not expect the buying to stop until the economy can stand on its own.

"The Fed is not going to prematurely tighten or remove accommodation," Michelle Meyer, U.S. economist at Bank of America Merrill Lynch, told CNBC. "That's what [Fed Chairman] Bernanke made very clear in his testimony."

Doug Foreman, co-chief investment officer at Kayne Anderson Rudnick Investment Management, echoed those comments. The Fed won't start to pull back "until they can see the whites of the eyes of an economic recovery," he said.

That may still be a few months off, as overall growth remains sluggish. Economists expect revised first-quarter gross domestic product numbers Thursday to show only a 2.5 percent expansion.

But there are encouraging signs that consumers have been resilient, despite the weakness. Consumer confidence numbers Tuesday were pretty much at pre-recession levels, Meyer said, calling recent consumer data "a pretty decisive turn in consumer confidence."

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The jobs data remain paramount, however, given the Fed's instance that any change in monetary policy will be driven by the economy—particularly a rebound in the labor market.

This Thursday, markets will get figures on weekly jobless claims to scrutinize for signs of improvement in the jobs market. The next employment report is due a week from this Friday, and economists expect creation of 165,000 nonfarm jobs and 7.5 percent unemployment, according to estimates from Reuters.

Consumer data will be the focus again Friday with the release of April personal income and spending numbers, as well as a May consumer sentiment reading.

"As the summer months progress, the economy will look a lot better than people think," Deutsche Bank economist Joe LaVorgna said. That could let the Fed start tapering in September, he added.

If the economy keeps getting better and the Fed is able to taper, investors may want to consider more economically sensitive cyclical areas. By the time the Fed is ready to curtail its bond purchases, the "rotation from defensive to cyclicals will be well underway," said Art Hogan at Lazard Capital Markets.

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"Think about what's going to play out over the next 12 to 24 months, which will be much more cyclical in nature," Hogan told CNBC. "You want to look at technology; you don't want to look at utilities."

Over the past three months, financials, consumer discretionary and technology have been among the market's best-performing sectors, while utilities have lagged badly.

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While they've already started to move, cyclicals remain cheaper than their defensive counterparts, potentially giving them more room to run.

According to Sam Stovall at S&P Capital IQ, defensives are trading at about 17.5 times 2013 earnings, versus 15 times for cyclicals and 15.9 times for the broader market. He said he likes consumer discretionary and is "warming" to industrials.

Other strategists agree. Jerry Castellini of CastleArk Management told CNBC that he likes financials, industrials and energy, which will benefit as the economy improves. "The greatest thing the market could have happen to it would be for the Fed to taper," he said, as it would mean higher earnings for some of the market's riskier areas.

"So far in May, we've seen a big rotation out of defensives, and I think this continues through year end," said Savita Subramanian, strategist at BofA Merrill Lynch. "While the easy money in the market might have been made at this point, the way to play equities is to focus on the undervalued cyclical growth options that are trading at pretty depressed multiples."

By CNBC's Justin Menza.