How to Choose the Right Sectors for This Economy

In the past month, investors have been moving out of relatively safe drug company stocks and picking up riskier technology issues. This shift of sentiment from one sector to another is known as sector rotation. If you understand the factors that drive sector rotation, you can learn to take advantage of it.

In a previous column, How to Make the Right Sector Calls, I gave my one-year outlook on the various sectors that comprise the S&P 500 index. But this forecast will become dated as the economic cycle rolls on. To help you update the forecasts, I have prepared the chart below showing how sectors respond at different stages of the economic cycle.

Guide to Economic Cycles

The chart is organized as follows: The outermost ring, labeled "The Economy" is green when the economy is expanding, gray when the economy is coasting and blue when the economy is slowing or even shrinking. (Read the chart in a clockwise direction.)

The next ring shows how the Federal Reserve responds to the state of the economy. Typically, Fed policy is accommodative (green) when the economy is growing slowly or in recession, and is more inclined to lower interest rates and increase growth in the money supply. We are exactly at that point right now. U.S. gross domestic product -- a key economic indicator -- grew at a rate of 1.4% in the fourth quarter of 2000, the lowest since the second quarter of 1995. January's Purchasing Manager's Index figures, out today, confirm the slowdown. We have already had two cuts in the Fed funds rate in the past month, and market expectations are for another cut at the March meeting.

These sectors are most closely correlated with expansion and contraction of the economy:

• Capital goods (factory machinery, aircraft)

• Consumer cyclicals (automobiles, housing)

• Technology (computers, telecommunications)

• Transportation (airlines, shipping)

As the economy expands, there's more demand for goods, and thus more demand for capacity to make and deliver goods. Also, with falling unemployment and rising incomes, consumers are more likely to spend on cars and houses.

Because the stock market generally anticipates economic conditions by about six months, the best time to buy companies in these sectors is when economic growth has slowed and interest rates are falling (i.e., right now). The worst time to buy these companies is when a fast-growing economy starts to slow, as we saw in 2000.

These sectors do best toward the end of an expansion:

• Basic materials (steel, aluminum)

• Energy (oil, natural gas)

When U.S. and world economies are running fast, demand outstrips supplies of basic materials and energy. Prices rise accordingly, boosting the stock prices of related companies. However, the window where you can take advantage is short. Once economies slow, prices on basic materials fall back to the cost of production, and stock prices of these companies fall also.

These sectors do best when the economy has slowed:

• Financial services (banks, insurance companies)

• Utilities (ignoring California utilities right now)

These companies have higher-than-average dividend yields, so they become more attractive to investors seeking safety. The main boost comes from falling interest rates in a slower economy -- the dividends are valued higher, and lower rates often boost bank earnings (both sectors did well in 2000). Stock prices in these sectors fall when rates are rising, so they're best to avoid in the late part of an economic expansion, especially when the Fed is boosting the Fed funds rate.

These sectors do best heading into recession, and stock prices here are often inversely correlated with the state of the economy:

• Consumer staples (food, toothpaste)

• Health care (drugs, HMOs)

Regardless of the state of the economy, consumers still buy food and health care. So while the earnings of these companies don't expand much during a recession, investors seek these companies anyway because of the reliability of their earnings. However, once the economy starts to expand again, these companies are sold in favor of technology, capital goods, etc. That's what we're seeing now.

Economic cycles in the U.S. last about five years on average, so the current cycle, which started in 1990, is a bit unusual. Also, we expect the current slowdown to be fairly short, with GDP growth rates heading back above 3% by the third quarter. So, at my money management firm, we are rebalancing our portfolios away from safety (especially health care, where we're overweighted) back toward growth (technology especially, but also retail stocks and capital goods). We're keeping our financial services positions flat, and shying away from energy stocks for a while.

The chart obviously simplifies a lot of detail but should give you a graphical understanding of the relationships between sectors and the state of the economy. You can also go the other way -- looking at the relative performance of the sectors to see where the economy is heading. You can do this by graphing the sector indices or looking at the sector performance charts. (These tools were described in a previous column, Making the Most of Your Sector Plays.)