A Change In The Air

As rallies mature, they go through different stages.  First, there’s the anything goes rally where low quality investments rally along with high quality.  Mutual funds go up, stocks and bonds go up, exchange traded funds go up.  Just about every sector goes up.  It’s not about what to buy, it’s just about getting more long and reducing cash.  Then, you get to the part in the rally where there’s a little more analysis done on which company should be added to a portfolio.  The low quality stocks start falling behind and are culled out.  Companies with real sales, real earnings, low debt, high return on equity, etc. get the new money.  That’s the stage we could be entering now.  It’s not a horrible thing.  It doesn’t necessarily signal the top in the market.  But, it’s going to require you to do a lot more homework than what you’ve been used to since March.

In addition to this change that may be upon us, there is also a potential change in sector leadership.  When an economy is recovering, the types of companies you want to own are the ones that are directly tied to the economy.  These are called hypercyclical companies.  This would be a Caterpillar for example.  It could also be a technology company or a financial company.  Naturally, those have been the leaders in this rally.  Companies that are consumer non-discretionary (staples) are the ones that have lagged.  Those aren’t as sensitive to the economy and therefore don’t move up as fast when the economy is re-accelerating.  In fact, looking at this sector, it’s underperformed the S&P 500 by about half since March.  But, in the last few days, I’ve noticed a rotation.  Perhaps investors are beginning to worry that the end of the recovery is near.  They don’t want to exit stocks, but just change which ones they own.  Consumer staples can hold up better in a rising rate and/or a sluggish economic environment which I think 2010 could look like.

Keep an eye on this rotation along with a rotation out of junk and into higher quality over the next few days and weeks.

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