Picking the Best Sectors for the Coming Months, Part 1

In my experience, 50% of a typical stock's return comes from the overall direction of the stock market, 30% from its sector and only 20% from company-specific factors. That means making the right sector bets can make a huge difference in your portfolio's performance.

In this two-part column, I'll examine which sectors look attractive now given recent world events and the current state of the economy, and point out resources you can use to do some research on your own.

Earlier this year, I wrote columns on "How to Make the Right Sector Calls" and "How to Choose the Right Sectors for this Economy." In these articles, I described how different sectors of the stock market respond to different points in the economic cycle. Let's start by reprinting a chart from my Feb. 1 column that summarizes this information.

At the time I wrote the article, my "best guess" was that we were most of the way through an economic slowdown. Even if the economy wasn't technically in a recession (as defined by two quarters of negative GDP), we were certainly in the midst of a corporate earnings recession. As expected, the Fed has just begun a cycle of interest rate easing. Typically, the economy doesn't turn higher for at least six months after the start of a Fed easing, so it wasn't surprising to us that economically sensitive stocks performed poorly through April.

In April, we concluded that the worst was past for this economic cycle. At that point, our equity allocation was 75%, and we began increasing this allocation until we reached a 90% weighting by August. Of course, we were completely wrong-footed by the Sept. 11 attacks.

In the first week after markets reopened, we decreased our equity exposure to 80% by selling stocks we thought would be hit the worst. These included American ExpressAXP, BoeingBA, stocks most sensitive to a slowdown in energy demand like drillers SchlumbergerSLB and HalliburtonHAL, and any companies with "speculative" earnings (i.e., companies whose current valuations depend on 30%-plus forward growth rates). Because we don't own airline stocks even in the best of times, we didn't need to decide whether to sell these or not.

So the big question is -- obviously -- what's next?

I always tell my clients that two things kill the stock market: the Fed raising rates and the outbreak of war. In the first case, higher interest rates lower the value of future earnings, leading to P/E compression and lower stock prices. In the second case, greater uncertainty about the future decreases the willingness of investors to hold risky assets like stocks.

Had the Sept. 11 attack occurred in March 2000, I would have expected the stock market to fall by 50%; instead, the decline was limited to about 12% in the S&P 500, which was soon gained back. While I don't expect to get back to a 90% equity allocation until this terrorist threat is neutralized (and who knows how long that will take -- a year? two years? 10?), there are plenty of stocks with valuations well off peak levels. How best to sort through these opportunities?

In Part 2 of this column, I'll show you where to look on the Net to find information to help you do this, as well as give you my own thoughts on which sectors look the most promising.