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Amid the hoopla over the six-year high in the
Dow Jones Industrials
, it's easy to neglect three more important milestones facing investors today: the transition of the economy from fast to slow, the switch from an expectation of interest rate increases to rate cuts, and the handover of market leadership from small stocks to large.
As these transitions gain traction, investors need to develop a new strategy for building wealth via the markets or face a lot of heartache. Before I explain -- and give you a list of 25 stocks well-suited to this environment later in this column -- let's review how we got here.
For the past three years, the U.S. economy has run at close to full speed, sort of like a car barreling down an interstate. That kind of behavior leads businesses to burn up a lot of raw materials and hire employees, driving up prices and wages.
You might think that federal authorities would love that, but they don't. Higher prices and wages, also known as inflation, are Public Enemy No. 1 to investors worldwide who keep our country in business by buying U.S. government-issued bonds. The most important job of U.S. central bankers, the folks who run the
, is to keep prices stable.
The Fed tapped the brakes on our runaway economy by raising interest rates for 17 months in a row through July. Higher rates make it harder for companies and individuals to borrow money, slowing down business expansion and consumer purchases.
If the Fed has done its job right, then the economy's growth rate should slow from a 6% annualized pace in the first three months of the year to around 2% over the next six months and never go negative. The first evidence of the Fed's success was the souring market for home sales, as mortgage rates soared and home affordability plunged.
And now signs are piling up that manufacturers of all stripes, from big automakers to little toymakers, are making fewer sales and hiring fewer people. Wealthier consumers are still buying stuff, but even sales at high-end retailers like
For the past two-and-a-half years, investors largely treaded water amid the long series of interest rate increases. It's been an environment in which small-company stocks have found favor due to their nimble spirits, while large companies' stocks malingered.
So what is the right strategy now that the Fed has taken its foot off the brake and its next move on interest rates is likely to be the first in a series of cuts?
The long history of the stock market provides insight on the probabilities. Let's take a look, courtesy of data from the excellent institutional-analysis firm Ned Davis Research.
Since 1950, after the last increase in a long rate-tightening campaign, U.S. economic growth has slowed to around 1% on average over the following year, while unemployment has risen 0.7 percentage point, corporate profits have flattened or fallen, inflation has stabilized, stocks have slipped and bonds have risen.
How much have stocks tended to fall? Well, in 12 of the 15 cases since 1920, a bear market was already under way at the time of the last increase or began no more than four months later. That's because the Fed usually overshoots with rate increases, killing the economy instead of just putting it temporarily to sleep. Ned Davis' studies show that from the last increase to the first cut since 1920, the Dow Jones Industrial Average has been down by a median of 9%. The
has fared better but still poorly, with a median loss of around 2%.
If you've wanted to stay in the stock market from the last increase to the first cut, then big-caps have been the way to go. In 10 of the past 13 cases over the past 85 years, small-caps have been down by an average of 7% from the last increase to the first cut.
Ned Davis' stats show similar problems for technology and growth stocks, which have been down 7% on average during the tightening-to-easing transition since 1974. In contrast, the Dow Jones Utilities Index has been up by a median of 6% during those transitions.
You can see that the current market has already started to adjust to this forecast: We have a new high for the Dow Industrials, while all measures of smaller stocks, and tech stocks, are well below their all-time highs. For this year, the S&P Small-Cap 600 is up just 3%, while the Dow is up 8%. That's quite a turnaround from 2004 to 2006, when the Small-Cap 600 was up 30%, while the Dow was up just 3%.
To be sure, it has on rare occasions turned out better for all. In 1995, the major indices rose by more than 10% from the time of the last rate increase in February to the first cut in July, with the
strongest and the Dow Jones Utilities weakest.
But Ned Davis points out that prospects for the economy were a lot stronger in 1995 than they are today, with crude oil at $20 and corporate profits accelerating at a zoomy 40% clip vs. the rather average 18% clip we see today. The analysis concludes that until the Fed starts cutting rates, the Dow's price/earnings ratio will likely slide from its current perch around 18 toward the historic median of 14 while corporate earnings slow and stock prices fall.
Of course, not all is woe in the transition forecast, as certain groups of stocks tend to far outperform the median. According to data from six rate-cycle transition periods since 1972, Ned Davis' analysis indicates that rate-sensitive and defensive sectors tend to lead. We're talking financial services, consumer staples and health care. Laggards tend to come from technology, industrial materials, retailers and industrials.
Among the financials, asset managers, reinsurance companies, real-estate investment trusts, investment banks and property insurers have tended to do best, with an edge to the apartment REITs. Among consumer staples, food and pharmaceuticals have the edge.
As for the laggards, well, companies tied to the economic cycle, such as semiconductor makers and newspapers, usually do worse, but they've done so badly over the past few years that it probably doesn't make sense to distinctly underweight them in portfolios.
Good news? Yeah, there's some. The first rate cut typically comes six months after the last increase. And as investors begin to sniff it out, consumer "discretionary" sectors, such as retailers and apparel makers, typically do great; industrials and materials pick up; drugmakers continue to succeed. Those that tend to fade at that point are the financials, as investors take profits into the good news. If July was the last rate increase, then figure the first cut could come as soon as February next year.
Some top choices for six-month holds are listed in the following table.
At the time of publication, Markman had no positions in stocks mentioned, although positions may change at any time.
Jon D. Markman is editor of the independent investment newsletter The Daily Advantage. While Markman cannot provide personalized investment advice or recommendations, he appreciates your feedback;
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