Stocks to Consider for Third Year of Bull Market

The bull market in stocks celebrates its second birthday this week amid unrest in the Middle East and soaring commodity prices, which has investors wondering if the winning streak can continue.

Even though the S&P 500 Index has almost doubled since the low set during the dark days in March 2009, money managers say defensive and late-economic-cycle sectors are the best bets for investors as returns diminish, highlighting stocks such as Exxon Mobil and Teva Pharmaceutical.

Close-up of a pen on stock price chart
Close-up of a pen on stock price chart

Every S&P 500 industry has climbed during the two-year rally, with most of the gains coming during the first year. Over the past 12 months, though, returns have been subdued. From March 2009 until March 2010, the benchmark index surged nearly 70%. Since then, the broad stock-market index is up 16%.

Most professional investors and analysts expect the rally to continue, but the magnitude of the advance should continue to decrease, they say. According to Standard & Poor's Equity Research, the S&P 500 has a mean return of 3.4% during the third year of bull markets since 1970. Three of the past 10 bull markets since 1949 were stopped short of a three-year birthday mark.

"As a result, investors likely preferred larger boats, as they expected the seas to become a bit more treacherous," Sam Stovall, chief investment strategist with S&P Equity Research, wrote in a research note Friday.

Stovall says large-cap stocks, which typically underperform small-cap stocks in years one and two of a bull market, tend to rise an average 5% to small caps' 2% gain in a third year. As a result, investors increasingly rotate through sectors during a bull market's third year.

Since 1970, Stovall says, investors dump cyclical sectors like consumer discretionary, financials and materials, which typically outperform during the first two years of a bull market. Investors move into later-cycle, early-defensive industries such as energy, health care and consumer staples. What isn't certain, though, is the timing.

Ari Wald, an equity analyst at financial-services firm Brown Brothers Harriman, says more reasonable expectations are appropriate now.

"We stress that we lack firm evidence to support the end of the bull market," Wald writes in a research note. "However, history indicates it is reasonable to expect the slope of the uptrend to flatten as the bull market matures."

Michael Sheldon, chief market strategist at Westport, Conn.-based RDM Financial Group, highlights several overhangs, including the fragile economic recovery, tepid job growth, geopolitical friction out of the Mideast, and rising commodity prices and food-cost inflation.

"There are major structural deficits and the potential for rising interests, taxes and inflation down the road," Sheldon says.

According to data released by Swiss bank UBS last year, the last secular bull market ended in 1999. Since then, the stock market has been mired in a secular bear market. The data, which date back to 1906, show that the last three secular bear markets lasted an average of 17 years. Indeed, the S&P 500 has about doubled in the past two years, but the index is still down about 15% since Oct. 9, 2007.

"What we're seeing now could easily be another short-term cyclical bull market within a longer-term bear market," Sheldon says. "Investors need to understand that this bull market may not last forever. Beneath the surface, there are issues."

Still, Neil Massa, senior equity trader for Boston-based John Hancock Asset Management, says the rapid increase in equities has turned it into a market for stock pickers, making it tougher to find success.

"You have to make sure it is on fundamentals and not because all the money out there is inflating them," Massa warns. "You're going to want to be in more defensive names in those sectors that have proven revenue streams."

For now, though, investors may be reassured of a historical trend in which the S&P 500 has an average return of more than 3% in the third year of a bull market. Money managers such as Sheldon offer their best ideas for sectors to watch over the next 12 months, detailed on the following pages.

Energy Sector

According to S&P Equity Research, the energy sector has performed best in the third year of bull markets since 1970, returning 16.2% to investors. This time around, energy stocks already appear to be a good bet for the next year.

Uprisings in the Middle East have led to surging crude prices. Violent protests that led to the ouster of Hosni Mubarak in Egypt have also unsettled Libya, where anti-government protesters are rebelling against Moammar Gadhafi's regime. Those uprisings have sparked similar protests in other Middle Eastern and North African countries, including Bahrain, Saudi Arabia, Yemen, Tunisia, Cote D'Ivoire and even Iran.

Since the Egyptian protests began Jan. 25, oil prices have steadily risen above $100 a barrel, taking a toll on the broad stock-market index. However, 15 of the top 25 best-performing stocks on the S&P 500 are energy-related companies, including Chesapeake Energy and Chevron .

RDM Financial's Sheldon say the energy sector is clearly the beneficiary of the rise in oil prices. For investors, he recommends diversified energy exposure on a global basis, while also looking for dividend yields.

Sheldon's firm has $650 million in assets under management, and it doesn't make big bets on stocks or mutual funds. Instead, the firm has many equally weighted stocks in the portfolios that RDM owns.

While Sheldon declines to offer specific equity picks, other portfolio managers have recommended Exxon Mobil because of the company's international exposure, revenue growth, access to capital and dividend payment.

Health Care Sector

With the uproar over health-care reform in the U.S., it's no wonder health-care stocks have lagged the market. The Health Care SPDR ETF is up 44% since March 2009, about half that of the S&P 500.

As the chart above shows, Teva Pharmaceutical has been one of those laggards. But with later-cycle, early-defensive sectors like health care expected to outperform this year, at least one fund manager expects Teva to be a winning pick.

Albert Meyer, manager of the Mirzam Capital Appreciation Fund , used to work with noted perma-bear investor David Tice of the Prudent Bear Fund . Rather than capitalize on the market with short bets, Meyer goes long on companies that don't have egregious executive compensation programs, which has brought him to Teva.

Meyer says Teva's long-term strategy is "very sound," referencing the bullish argument that a generic drug maker like Teva will be able to capitalize on the expiration of drug patents that other companies will be facing shortly. With baby boomers aging and middle classes forming in emerging markets, Teva seemed like a surefire bet for many investment managers.

But Teva's shares have underperformed, falling 16% over the past 12 months. "I'm puzzled by the lack of performance, but I'm not disappointed and I'm not giving up," Meyer says.

One of the company's weaknesses has been Teva's multiple-sclerosis drug, Copaxone, which ironically faces competition from generic drug makers. "They are fighting that and appear to be very successful," Meyer notes. "I think they'll grow their generic part of their business to offset this."

The good news for Meyer—and Teva shareholders—is that S&P Equity Research data show that the health-care sector has an average return of 9.5% during the third year of a bull market.

Consumer-Staples Sector

It took a 150% rally from the March 2009 low, but the consumer-discretionary sector now has a positive return of nearly 4% since Oct. 9, 2007, when the market was at an all-time high.

Consumer staples, on the other hand, rose just 55% since the March 2009 low, and yet the sector is the best performer since the market's record highs in late 2007. Investors who took a cautious approach to limit downside risk are winning, even taking into consideration the epic market collapse and recovery.

What's more, S&P Equity Research data show that consumer staples typically rise 8.3% in the third year of a bull-market rally. Consumer staples are considered safe during economic downturns and high inflationary periods while typically providing big dividends to investors.

Suddenly, those boring defensive stocks like Kraft Foods , Procter & Gamble and Colgate-Palmolive don't seem so boring after all.

Johnson & Johnson may be grouped among health-care companies, but fund manager Russell Croft views the stock as a contrarian consumer-staples selection with a strong balance sheet and attractive dividend yield of 3.5%.

"It's not the sexiest name in the world, but it's a triple-A rated company," Croft says. "In terms of composition, J&J is 40% pharma and 35% medical devices, but it is 25% consumers. It has broad-based customers, and half the revenue comes from outside the U.S."

Based in Baltimore, Croft Leominster has $800 million in assets under management, with $325 million in the Croft Value Fund . Croft has been a co-portfolio manager of the Croft Value Fund since he joined the firm in 1997

While not necessarily a consumer staples name, Mirzam Capital Appreciation Fund's Meyer says Paychex would similarly benefit from a rebound in consumer spending.

Paychex, Meyer says, is allowed to take payroll deductions for taxes or Social Security or Medicare, and hold on to them for 31 days, which they then earn interest on. The stock has underperformed given high unemployment and low interest rates, but that could change soon.

"When interest rates are up, they have a $4 billion float that they don't own but on which they earn money," Meyer says. "So higher employment means more payroll deductions and more paychecks for them. And if interest rates increase, it will really boost their earnings. And they have a nice 3.7% dividend."

Telecommunications Sector

S&P Equity Research data show that, on average, the telecom industry climbs 6.7% in the third year of a bull market. While the sector has rebounded more than 40% from the March 2009 low, telecom is 30% below the level it reached on Oct. 9, 2007. Only financials, which are still down 50%, have more ground to make up.

Albert Meyer of the Mirzam Capital Appreciation Fund sees opportunity in telecom names.

"Telecom stocks have done OK, and they've been paying us great dividends," Meyer says. "When they wake up, it will be a great thing."

As the chart above shows, China Mobile and Telefonica , both foreign telecom providers, have underperformed the broad market over the past 12 months, a trend Meyer doesn't anticipate will continue.

Meyer notes that China Mobile had $25 billion in cash on its balance sheet two years ago, and that number has ballooned to $48 billion. Investors have punished the stock, angry that China Mobile hasn't increased its dividend. The stock yields 3.5%, while other telecom companies are paying nearly double that amount.

With more than 580 million subscribers and word that Apple is bringing its iPhone to the company's 4G/LTE network, China Mobile is "the ideal stock if you want exposure to China and growth in consumerism," Meyer says.

Telefonica, meanwhile, is a stock that Meyer's fund has owned for a while. The stock was crushed during the European debt crisis, but Meyer contends there is nothing wrong with Telefonica's business.

"They've given projections of future dividends, and they have the cash and ability to stick to that," Meyer says. "Some people say there is risk to the company's South American exposure. But if Carlos Slim could make a lot of money in the telecom business in South America, then I think Telefonica will as well."

Real-Estate Sector

Real estate investment trusts, or REITs, crushed the market last year while paying massive dividend yields.

The Dow Jones Equity All REIT Total Return Index climbed 25% last year, nearly twice that of the benchmark S&P 500 Index. That's on top of a 33% advance in 2009.

But will those returns keep up, especially with fear that the housing market still isn't recovering strongly? Jay Leupp, senior portfolio manager of the San Mateo, Calif.-based Grubb & Ellis AGA Funds , says demand for high yields will continue to drive REIT share prices higher.

"REITs should raise their dividends over 5% this year over last year, and 4% next year," Leupp says. "That should provide enough momentum to push share prices higher."

For instance, Glimcher Realty Trust has more than doubled over the past 12 months. Despite the rapid ascension of its share price, Glimcher Realty still pays a 4.5% dividend yield. Like other REIT stocks, that yield easily outpaces the 3.5% yield on the 10-year U.S. Treasury bond.

Leupp says it isn't all about dividends with real-estate stocks. He expects the sector to continue to recover.

"The fundamental momentum across the board is positive," Leupp says. "Supply is constrained, rents are growing. Occupancy levels are starting to rise. Landlords have more pricing power. All of that leads to earnings growth, dividend growth and higher share prices."

What's different, Leupp says, is that real estate stocks, like the market, are moving back to a period of normalized returns. He estimates that 4% to 6% of return will come from dividends and only another 5% to 7% will come from appreciation. The key for investors, he says, is to buy REITs that continue to boost earnings.

"Earnings growth leads to dividend growth, and that will be the ultimate driver of share prices," he adds.