Three Ways to Spin Sector Rotation to Your Advantage - TheStreet

Three Ways to Spin Sector Rotation to Your Advantage

Look for lasting shifts and catch stocks that can move up with the tech and blue-chip crowd.
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When technology stocks go up, do blue-chip growth stocks have to go down?

Seems like it lately. Take a day such as Tuesday, Dec. 12. The

Dow Jones Industrial Average

closed up 42 points; the

Nasdaq Composite

fell 83. Blue-chips such as

Procter & Gamble

(PG) - Get Report

,

Johnson & Johnson

(JNJ) - Get Report

and

McDonald's

(MCD) - Get Report

climbed 4%, 1% and 3%, respectively. Technology stocks such as

Applied Materials

(AMAT) - Get Report

,

Ariba

(ARBA)

and

Inktomi

(INKT)

fell 11%, 12% and 8%, respectively.

That abruptly reversed the pattern from Dec. 4 through Dec. 11, when technology stocks far outperformed blue-chip growth stocks. Over that week, as the Nasdaq climbed to 3015 from 2615, or 15%; Applied Materials, Ariba and Inktomi soared ahead 32%, 41% and 123% in order. Procter & Gamble fell 8%, Johnson & Johnson declined 4% and McDonald's dipped 5%.

That pattern is called "rotation," and we've seen a lot of it during the past month. Every time investors got a little spooked, they took money out of "risky" technology stocks like, say,

JDS Uniphase

(JDSU)

, and stuffed it away in a "safe" stock such as

Merck

(MRK) - Get Report

or

Pfizer

(PFE) - Get Report

. When the danger passed, the flow reversed. Money came out of the safe blue-chip growth stocks and went back into the more volatile technology names. And with the chaos surrounding the presidential election keeping new money largely on the sidelines, the movement of cash from one sector to another was pretty much the only source of funds to drive stock prices up. So when one sector got hot, another was just about guaranteed to cool down.

Rotation can sure make an investor's life tougher. Abrupt shifts in direction on no news and with no warning can turn a profitable pick into a loser and then back again over the course of a few days. A strategy that was sailing along can suddenly founder. Enough of this whiplash and an investor can start second-guessing everything. Or even worse, investors may jump from trend to trend, usually just far enough behind the curve to make each move a money-losing one.

So how do you profit from a market characterized by heavy sector rotation?

First, make sure you understand what is driving the rotation.

Second, try to separate the split-second turns in direction that you're likely to catch only by luck from the more lasting shifts that you might actually be able to anticipate.

And third, look for stocks that have enough of a foot in each camp -- blue-chip growth and technology, currently -- to keep them going up no matter what the market's short-term mood may be.

OK, let's start with the factors likely to keep this market spinning as we end 2000 and move into 2001.

Earnings Worries vs. Rate-Cut Hopes

With the presidential election removed as a distraction, this market becomes a clear battle between hope for falling interest rates and fear of earnings disappointments. After the market closed on Dec. 12,

Compaq Computer

(CPQ)

warned that it would miss analyst estimates for fourth-quarter earnings by 6 cents to 8 cents a share. That announcement focused investors on potential earnings disappointments. Analysts quickly got busy speculating that

Microsoft

(MSFT) - Get Report

, the parent of MSN MoneyCentral, or

Dell Computer

(DELL) - Get Report

would be the next technology company to warn. Investors sold the technology-heavy Nasdaq Composite -- it fell more than 100 points on Dec. 13 -- and bought the Dow Industrials -- it climbed 25 points. Safe drug stocks such as

Schering-Plough

(SGP)

hit new 52-week highs.

But I expect that as we get closer to the

Federal Reserve Open Market Committee meeting on Dec. 19, attention will shift to hopes that the central bank will signal its plans to cut interest rates early in 2001. Those hopes would probably be enough to fuel a strong rotation back into technology stocks, especially if stocks in the sector have backed off again to very attractive prices.

It's not that an interest-rate cut would help only technology stocks, of course. But high-price-to-earnings tech stocks that have been hammered by fears of a capital-spending slowdown would be good bets to bounce back faster and higher than blue-chips that have already appreciated as the market rotated toward safety. And if, because of

Federal Reserve rate cuts, the economy isn't going to slow as much as everyone feared, then these high-multiple stocks aren't quite so risky either. Suddenly, a stock with a P/E ratio of 400 and a potential revenue growth rate of 100% or more will seem a better buy to some investors than a blue-chip growing earnings by 15% and trading at a P/E of 25.

Big Moves Easier to Catch

Can you play a rotation like this -- selling stocks in the group that's about to go out of favor and buying stocks in the group that's about to climb? The bigger the rotation -- in points and time -- the easier it is to take advantage of such a move. Catching very short-term moves is largely a matter of luck. And it takes a very confident trader, much more confident than I, to remodel enough of a portfolio, quickly enough, to make a significant profit on such a move.

I am comfortable, however, trying to catch bigger moves. My minimum is a 6% gain or slide in the blue-chip sector and a 10% gain or slide on the technology side. (I use the Dow Industrials average and the Nasdaq Composite indices as a quick way to keep a watch out for those kinds of moves.) For a switch to work, of course, these two indexes must make these minimum percentage movements at roughly the same time.

For example, the 25% drop on the Nasdaq from Nov. 3 to Nov. 30 would certainly have qualified on the technology side, but the Dow actually fell during that period. So there was no rotation trade opportunity.

But there was a reasonable rotation opportunity earlier in October. From Oct. 18 through Nov. 6, the Dow climbed 10%. At about the same time, from Oct.18 through Nov. 22, the Nasdaq fell 13%. (The Nasdaq hit bottom on this cycle at 2598 on Nov. 30.) That turned out to be a good opportunity for a rotation trade, since the Nasdaq proceeded to climb to 3015 on Dec. 11.

You don't have to turn over your complete portfolio to take advantage of a window of opportunity like that. I don't. Instead, I use these rotations as a chance to sell a few stocks that have racked up what look like unsustainably rapid gains when the cycle was in favor. And I use it to pick up a few stocks that sold off severely when the sector was out of favor but that have the potential to deliver good gains when the market rotates.

Want an example? Well, from Oct.18 to Nov. 6, McDonald's gained 14%. By the time the stock peaked on Nov. 22, the total gain came to 22%. A 22% one-month gain in a blue-chip at a time when rotation rules the market would signal a sell to me. If I'd put that money immediately into Inktomi, I certainly wouldn't have hit the bottom of the cycle for that stock, which didn't come until Nov. 27, but I still would have caught a 73% gain by Dec. 11. And even for a technology rocket, I'd have to say that 73% in less than a month qualifies as unsustainable.

Even if you find this write-up intriguing, I think you're entitled to feel skeptical until I alert you to a rotation trade as it's happening instead of one that's conveniently in the past. After all, anybody can go fishing in past data and find an example to prove just about anything. So I'll be on the lookout going forward for a rotation trade that we can try as it unfolds. That will be the real test.

Watch the Warnings Reactions

But we don't have to wait for that moment to get something useful out of my market-rotation analysis. Knowing what factors are driving these rotations, and this market in general, can supply guidelines for the type of stock likely to show the best gains through both halves of a rotation. In the technology sector, I'd be looking for stocks that have already warned -- perhaps repeatedly -- but that fell very little on the last warning. Since these stocks have already warned, they've put most of their earnings risk behind them, at least for the next quarter, and they have a solid chance to do well even when the rest of the technology sector rotates out of favor. For example,

WorldCom

(WCOM)

, a stock that has warned repeatedly about the current quarter, gained 12% from Dec. 11 to Dec. 13, even while the technology sector retreated.

On the blue-chip side, I'd look for stocks that are still trading at substantial discounts to their 52-week highs. These have a chance to continue to gain when investors rotate into "bargain" stocks as they start to focus again on the potential for a Federal Reserve interest-rate cut. Procter & Gamble, which is still about $46 a share below its 52-week high of $118, is a good example of that kind of blue-chip.

Finding stocks like Procter & Gamble on the blue-chip side and WorldCom on the tech side can take a while -- but it's a way to pass the time while you're waiting for the market to produce another tradable rotation. The current example that began on Dec. 12 isn't big enough yet -- but it is worth watching. From the close on Dec. 11 through the close on Dec. 13, the Dow was up 1% and the Nasdaq was down 6%. Keep tuned to this channel.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Applied Materials, Ariba, Inktomi, Microsoft and Puma Technology.

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