How to Play Equities in the Second Half of 2012 — Think U.S.

The smart money seems to be split over whether the defensive or cyclical sectors will drive the stock market during the second half of 2012. But one thing is clear — companies that cater to U.S. consumers will lead the charge.

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“Investors are insulating themselves from the problems in the rest of the world by owning parts of US-based companies that do business in the states.” says Joe Zidle, portfolio strategist for Richard Bernstein Advisors in New York. “Everyone loves to trash the U.S., but contrary to popular belief we are further along in our recovery than the rest of the world. Relative to our asset allocation benchmark, we are massively overweight in the U.S. right now.”

Scott Wren, senior equity strategist for Wells Fargo Advisors, agrees domestic stockswill benefit over the next few quarters from growing consumer confidence in the U.S. economy, and worries over the eurozone debt crisis.

“In this type of global environment, our modest growth and modest inflation economy looks pretty good,” he says. “Our domestic growth is viewed as dependable, something you can count on. Given that, I believe the U.S. has become the safe-haven equity market for global investors, much like our Treasury markethas always been.”

It’s less clear, however, which sectors present the greatest opportunities for growth.

Defensive View

For his part, Zidle of Richard Bernstein Advisors believes investors will increasingly seek safe-haven securities to insulate their portfolios against economic and political uncertainty, giving defensive stocks a shot in the arm.

Among them: utilities, telecommunications, health care and consumer staples. These equities tend to perform well when the economy falters because demand for goods and services that those companies provide remains constant. Consumer staples include companies that make food, beverage and household products.

“Over the next couple of months, people are going to be waking up to the headline risks in the U.S., including the presidential elections and the fiscal cliff” that could shock the economy if Congress fails to act on a host of budgetary provisions, which are set to expire or take effect on Dec. 31, says Zidle.

“Investors are going to be afraid so the stocks that set the agenda are going to be from the defensive side of the economy,” he adds, noting much of that sentiment is unfolding as the domestic economy continues to show signs of relative strength.

Cyclical View

Wren, on the other hand, believes cyclicals will pull ahead as 2012 draws to a close.

Such stocks are more sensitive to economic ups and downs, and generally favored when investors are bullish on the market. They include the consumer discretionary sector, comprised of businesses that sell nonessential goods and services.

Year-to-date, consumer discretionary stocks in the S&P 500 are up 10.5 percent.

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“It looks to us like employment will continue to slowly improve through the end of the year, and consumer confidence and spending will improve,” says Wren, who expects the S&P 500 index to finish the year at around 1,400 to 1,450, a 13-percent gain for 2011. “If you think the market is going to go up, it’s unlikely to be led by staples and healthcare.”

His advice to clients is to opt for consumer discretionary stocks tied to home improvement, retail and restaurants.

“My glass is half full,” says Wren. “In my opinion, we’re going to see a continuation of modest recovery here in the states and a continuation of global recovery as well. We want clients prepared and positioned for what we think is going to be the second leg up in the cyclical bull market.”

For the same reason, he notes, the materials sector is likely to outperform over the next few months.

The sector includes stocks from companies that mine or process raw materials used in construction, like metals, chemicals, oil and gas.

“Materials have been hit hard, but a lot of that was due to the slowdown in China,” says Wren, who believes China’s growth rate will bottom this summer in the 7.5 percent to 8 percent range. “We’re taking advantage of the sell-off that’s occurred and putting our money to work in the materials sector.”

The Big 3

Financials, Tech, Energy

Still, with all the uncertainty surrounding Europe, Asia, and the U.S. presidential election, it’s easy to see why investment strategists diverge on which direction Wall Street will take, says Kevin Rendino, portfolio manager for Blackrock Basic Value Fund.

“It’ll either be a combination of telecommunications, utilities, healthcare and consumer staples, or it’ll be the other side of the economy that drives the market — financials, information technology, materials, energy and consumer discretionary,” he says. “It’ll be one of those two groups, but it won’t be both.”

The challenge, he says, is figuring out “what the world is going to look like” six months down the road. And, more importantly, how investors will respond.

Historical precedent suggests the market may end higher for the year, giving investors the confidence to assume greater risk in their portfolios.

According to the "Stock Trader’s Almanac", years when an incumbent president runs for reelection tend to be bullish, regardless of which political party wins the Oval Office.

Election Factor

Since 1896, the Dow Jones Industrial Average has ended higher in 14 out of the 19 presidential elections in which the sitting president was on the ballot.

At the same time, the last seven months of an election year have seen only two losses in the S&P 500 index since 1952 — one in 2000 when the dot com bubble burst, and the other in 2008 when the Great Recessiontook hold.

No such anomalies are expected this year, says Jeffrey A. Hirsch, president of the "Stock Trader’s Almanac", who predicts the Dow Industrialswill end 2012 in the 10,500 to 11,500 range, 5 percent to 10 percent higher than 2011.

“Things are setting up seasonally and historically true to form,” says Hirsch.

Like Wren, Rendino believes cyclical stocks will steal the show during the third and fourth quarters fueled by investor optimism — and a wealth of opportunity for value investors.

“We think expectations are too pessimistic and that investors are doing the wrong thing running for the hills,” he says, noting valuations are not reflected in the price of many stocks. “There are stocks out there trading at lower levels than they did in 2008 and 2009 when the world ended, and most are in the information technology sector.”

As such, he says, it’ll likely be financials, info tech, and energystocks that "return in the back half of the year as we move towards a ‘risk on’ environment;” one in which investor sentiment is driven by confidence rather than fear.

Regardless of which sectors ultimately take the lead, investors seeking downside protection in the current market environment would be wise to insulate their portfolios with U.S. stocks, while maintaining their exposure to international equities, says Wren.

“You definitely need domestic stocks, but if you’ve got any kind of time horizon you’ve got to have some international exposure in a diversified portfolio as well,” he says, noting moderate investors' international equities allocation should be 20 percent — 25 percent. “If you look out over the next 10 or 20 yeas, the majority of growth will be in the emerging markets so clearly you’re gong to want some exposure there.”