How to Take Advantage of the Great (Sector) Rotation

One beneficiary of the 2013 US stock market rally: defensive sectors.

Until recently, classic defensive sectors like utilities, healthcare and consumer staples outperformed as investors were just starting to dip their toes back into stocks focused on those parts of the market many considered safer and less volatile.

But, as I wrote in my latest weekly commentary, over the past few weeks there has been some evidence that this is starting to change.

Utilities are down sharply in May, while healthcare and consumer staples companies are also shifting toward weaker performance. At the same time, we’ve seen better performance from energy, industrial, materials and technology firms, all of which are more cyclical in nature.

In other words, the real Great Rotation may just be a shift to cyclical from defensive sectors rather than a move to stocks from bonds.

The shift isn’t just a reflection of investors finally perhaps becoming more comfortable with risk. Despite the fact that profitability is actually somewhat lower for many companies in the defensive space, defensive valuations are at historically high levels. The three classic defensive sectors – healthcare, staples and utilities – are trading at an average premium of more than 10% to the market. By way of comparison, back in the fall of 2009, these three sectors were trading at an average discount of around 40% to the broader market.

Given this, the recent underperformance of some of the defensive names makes sense. It looks as if investors are starting to recognize that some of the more volatile companies are good long-term plays, and, at the same time, it’s possible to spend too much for a good night’s sleep.

So assuming cyclical sectors’ outperformance continues, how should investors consider playing this Great Rotation? Here are three ideas.

1.) Don’t completely abandon defensive sectors. Instead, investors should consider how much they’re paying for safety. In particular, the US utility sector looks quite overpriced and, despite its recent slide, probably has more downside. On the other hand, I currently advocate a benchmark weight to the healthcare sector.

2.) Consider the energy and technology sectors. Many of the cyclical sectors look cheap at today’s levels. In particular, current valuations of the technology and energy sectors represent good long-term values. These sectors are accessible through the iShares Dow Jones U.S. Technology Sector Index Fund (IYW) and the iShares Dow Jones U.S. Energy Sector Index Fund (IYE), respectively.

3.) Cast a wider net when looking for dividends. Part of the recent preference for defensive names has really been a preference for dividends in a world characterized by low nominal and real interest rates. But I would encourage investors to cast a wide net in their search for income and to look at dividend-paying companies from outside the United States, many of which look quite attractive. One way to access such firms is through the iShares Dow Jones International Select Dividend Index Fund (IDV).

Source: Bloomberg

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to theiShares Blog. You can find more of his posts here.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. There is no guarantee that dividends will be paid.

Narrowly focused investments typically exhibit higher volatility. Technology companies may be subject to severe competition and product obsolescence. The energy sector is cyclical and highly dependent on commodities prices. Companies in this sector may face civil liability from accidents and a risk of loss from terrorism and natural disasters.