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Slower Profit Growth Could Sink Cyclicals

Look for a pop in high-beta names after the Fed hikes. But don't expect it to last.

While a

Federal Reserve

interest rate hike or drop in oil prices could trigger a rally in economically sensitive stocks that have underperformed this year, enthusiasm for the names will be short-lived if they can't overcome another specter: decelerating profit growth.

Cyclical stocks, which rise or fall along with the economy, have generally declined this year as concerns about rising rates and soaring energy costs have sent investors back into the arms of more defensive issues. Defensive companies sell products and services that consumers always need regardless of the economic environment, so they tend to hold up well in times of uncertainty.

Dividend-paying stocks also have outperformed this year, rising 0.3%, compared with a 4% decline for companies that don't pay a dividend. Meanwhile, investors have shown a preference for value over growth. Value funds have fallen just 0.8% in 2004, compared with a 2.5% decline in growth funds, according to Lipper.

Still, some analysts say an increase in rates or drop in energy prices could reignite the so-called "beta trade" that was so lucrative for investors in 2003. Beta is another term for volatility.

"When the Fed actually does start to move rates, there'll be a bounce in the market, and a number of areas that have been hit hard will come back," said Ed Peters, chief investment strategist at PanAgora Asset Management.

Although the Fed has suggested it will raise rates at a "measured" pace, investors have been skeptical, and many fear a repeat of 1994, when the Fed raised rates six times. As it becomes more obvious that aggressive rate hikes aren't in the cards and that the economy isn't about to implode, Peters said, investors will be more willing to take on risk.

"Once the Fed starts hiking, we're likely to see a relief rally in which cyclicals, materials and industrials outperform again," agreed Carlos Asilis, fund manager at Vega Asset Management.

Only three of the

S&P 500's

10 economic sectors have shown positive returns so far the year: energy, consumer staples and telecom. The health care sector is flat. In contrast, materials are down nearly 9%, and technology is off by almost 6%.

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Merrill Lynch strategist Richard Bernstein said the catalyst for a rally in the cyclical sector could come from a precipitous slide in oil prices. So far this year, investors have worried that the liquidity spigot might be turned off through a combination of Fed tightening and rising energy costs, he said. But a rapid fall in oil prices "might be the source of liquidity needed" to send technology and consumer discretionary stocks higher.

If such a rally were to materialize, however, Bernstein said investors should use it as an opportunity to get into defensive, high-quality issues. In periods of decelerating earnings growth, higher-quality stocks -- or stocks with stable earnings and dividend growth -- typically outperform lower-quality names, he said.

From 1995 to 1998 -- a period in which the Fed was actually cutting interest rates -- high-quality stocks outperformed their low-quality counterparts by almost 13 percentage points, because the profit cycle was decelerating.

"The beta trade tends not to work when risk-aversion grows, and the two factors that tend to spur risk-aversion

slower earnings growth and rising rates seem to be gelling," Bernstein wrote in a research note.

Bill Rhodes, chief investment strategist at Rhodes Analytics, is also bullish on the defensive sector, noting that the period of strong economic growth acceleration is now over. The economy is expected to grow 4.7% this year, according to the National Association for Business Economics, but is expected to slow to 3.8% next year.

"We are in a market that has already transited from a very high-growth period to a period where margins are continuing to expand and sales are continuing to grow," but not at the pace seen over the past year, he said.

S&P 500 earnings, which rose 27% in the first quarter, are expected to rise 18% in the second quarter, 12.6% in the third and 14.4% in the fourth, according to Thomson Financial. In 2005, earnings growth is expected to slow to about 9% from almost 16% this year.

Although defensive names, particularly consumer staples and health care stocks, are not cheap after a recent run-up, some analysts say they continue to offer the best protection for investors.

Smith Barney analyst Tobias Levkovich, who predicted the current drop in stocks, is calling for another 10% decline in equities over the summer, saying upward earnings revisions are "unsustainable."

Investors who load up on cyclical names in anticipation of a rally after the first rate hike could well be disappointed, he said. "Unfortunately, when everyone moves to the same side of the boat, it is often in danger of capsizing."

Levkovich believes stocks should begin to improve in the fourth quarter and said that if the S&P 500 moves below 950, he would be "inclined to buy almost immediately." Until then, however, he recommends a defensive posture.

"We consider any upward movement in the markets ... to be an opportunity to lighten up on cyclical stocks as well as technology and financial names," he said.