Knowing where we are in an economic cycle -- or where we think we are -- can be critical to making the right stock-picking decisions.
Even if you're convinced that the burst of productivity associated with huge investments in new information technology has caused profound changes in the U.S. economy, there are still economic cycles -- established patterns of growth, inflation, and contraction. And different stocks perform better in each phase.
Where we stand now is harder to figure out than it used to be, given the anomalous record of high growth and low inflation in recent years. One thing is clear, however: The
Federal Reserve is trying to bring down superheated growth to avoid the inflation that is associated with the late stages of a business expansion.
So, the Fed has raised the short-term
fed funds rate by 1.75% percentage points in the last year to 6.5%, the highest level in nine years. Inevitably, the hikes will lead to slower growth as companies and consumers find the costs of financing -- from new plants to new cars -- rising.
Predicting a slowdown from rapid 5.4% growth last quarter isn't hard. What is hard is figuring out whether the economy will slow enough, soon enough to keep the Federal Reserve from raising rates many more times this year. And in turn, how prolonged the slowing will be and how slow will it go?
Generally, the nation's business cycles display periods of growth with declining inflation, followed by longer periods of growth with inflation. A model devised by
shows that U.S. investors are currently getting defensive, but remain optimistic that the economy, for now, is nearing a peak in terms of inflation. The model, constructed as a wheel, shows that investors look to different types of stocks when their perception of the economy changes. During a period of rising growth and declining inflation, it's time to bet on tech. Of course, that period lasted for quite a few years. When inflation bottoms but growth continues, as some believe it has, it's a signal to move into cyclical value stocks, such as oil, paper and chemicals.
The Global Sector Wheel of Fortune
Source: Merrill Lynch
However, Merrill's global strategist David Bowers points out the move into commodity stocks was strong for just a couple of months before U.S. investors began to shift into defensive value stocks. Indices such as the
Philadelphia Stock Exchange Oil Service Index
American Stock Exchange Natural Gas Index
seem to have topped out in recent weeks. In just a few months, the market went from taking Fed jawboning about inflation as gospel and pouring cash into commodity-type names to a view that growth was going to slow, but inflation was less of a threat.
Slowing or Not?
That sentiment, and the mix of sectors that strategists are looking at represents a sunnier outlook than Bowers would expect. They're looking at traditional slowdown-type stocks -- such as food, tobacco and utilities -- which people need at all times, but they're also looking ahead to "defensive growth" type stocks, such as insurance companies and pharmaceuticals, which are typically stronger when investors presume growth is soon to hit bottom.
Other sectors include capital goods companies such as
, because global growth is strengthening. This still-optimistic sentiment is a testament to the low-inflation environment that currently exists: Even if inflation does rise, it's still historically at very low levels. If growth slows, to say 3%, that rate would have been welcomed in the past.
"The uncertainty is the extent of a slowdown," Bowers says. "If you're going to get a slowdown, then you'd be a heck of a lot more defensive than if you're in a low-inflation, good-growth area. People are taking a more optimistic stance. The fund managers we're speaking to are getting more defensive, but they're going for quality, rather than cash. People don't believe we have an inflation problem."
That is, they believe the Fed won't raise interest rates much more this year. In addition, if rate hikes take 12 to 18 months to work their way into the economy, early evidence of a slowing should emerge later this year. If those signs emerge, the Fed could get out of the way, and that could usher in a period of steady, albeit slower, growth through 2001.
If the data start to show a slowdown, "the Fed will come to its senses and do only one more hike" this year, says Peter Canelo, U.S. investment strategist at
Morgan Stanley Dean Witter
. He believes the leadership once the market breaks out of this slump (and he does believe that will happen) will be dominated by "good companies from the old economy."
That last statement illustrates the problem with sector bets right now. It's a theory repeated by several strategists that the way to go may not be to concentrate on sectors, but rather on stocks with P/E ratios that rank in the bottom half of the
Are they poised for a move? Small caps like the
S&P 600 Small-Cap Index
have not gotten back on track since the entire market dropped in March and April. Of course, many of these low P/E stocks have been touted for a long time and haven't produced, but with technology spending expected to slow (and growth as well) it's much harder to justify a bet on the same technology stocks.
Canelo does foresee a time to get back into technology names. He says if the Fed is near the end of its current phase of tightening, technology leadership should reassert itself sometime around the presidential election and propel the market through 2001.
"I think you go back to tech before the end of the year as soon as you start to see more conviction about the slowing," he says. "We know that there's going to be the same old leadership problem.
and other very high P/E stocks may go sideways for a long time." He compared Cisco's valuation to
in the 1980s, a stock that eventually could no longer justify its valuation and went sideways for more than four years, despite the company's quality.