How to Find Reward in Riskier Sectors

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Some recent market weakness notwithstanding, riskier assets such as stocks have enjoyed an almost unbroken rally since late November. U.S. equities notched their best start to a year since 1997, while last year’s outperformers like long-dated Treasurys are lagging.

That means active investors who hope to generate market-beating returns need to think about tactical sector rotation, whereby they overweight the offensive areas of the market and underweight the defensive sectors. If dividend-payers, low-yielding bonds and cash are out, then early-cycle sectors like financials and tech, which move ahead of any pickup in the broader market, will continue to shine.

“Our view is that the ‘risk on’ trade is the right one in the long term given that the world’s major economies are healing and that debt problems are slowly improving,” says Bob Doll, chief equity strategist at BlackRock (NYSE:BLK), in his most recent note to clients.

Of course, the risk-on trade won’t not progress without fits and starts, Doll cautions. “The rise in risk asset prices, however, has been in a more-or-less straight line, with U.S. stocks rising close to 25% over the past four months,” Doll notes.

At some point we’ll get a pause, consolidation or even a correction, but as long as reduced fears from the European financial crisis and a better economic climate in the U.S. drive investors back into stocks and other risk asset classes, overweighting the pro-cyclical sectors of the market is the way to go.

The hottest sector of the market so far this year has been financials, according to Standard & Poor’s. The broader S&P 500 is up 7.5% as of Feb. 13, while the financial sector has gained 12.9%. Financials are early-cycle stocks, and they’re very sensitive to credit. That’s why the Federal Reserve’s pledge to keep short-term interest rates at near zero through 2014 has been a boon to all the most cyclically sensitive sectors.

So it should come as no surprise that the nation’s biggest banks are all generating market-beating returns in 2012. Bank of America (NYSE:BAC) is up 48%. Citigroup (NYSE:C) has gained 25%. JPMorgan Chase (NYSE:JPM) is up 15%, while Wells Fargo (NYSE:WFC) — which investors tend to overlook — has gained 11%.

After financials, tech stocks are booming — although that’s probably less of a surprise with Apple (NASDAQ:AAPL), the world’s biggest company by market cap, topping $500 a share on Monday. Shares are up nearly 25% for the year to date.

Thanks in no small part to Apple, the S&P 500’s tech sector has gained 12.5% so far in 2012. But even dowdier large-cap names are outperforming the broader market. Microsoft (NASDAQ:MSFT), a component of the Dow Jones Industrial Average, has gained 18%. Fellow Dow components Hewlett-Packard (NYSE:HPQ) and Cisco Systems (NASDAQ:CSCO) are up 12% and 11%, respectively. Blue-chip tech has been a heck of a bet.

The other two areas of the S&P 500 putting up double-digit percentage gains this year are the materials and industrials sectors. Basic materials like iron ore, copper and aluminum are exquisitely attuned to global economic growth, especially from resource-hungry nations like China. That helps explain why aluminum giant Alcoa (NYSE:AA) is up nearly 20% this year — and was InvestorPlace Editor Jeff Reeve’s top stock pick for 2012.

Iindustrial companies that help get those basic materials out of the ground are also going gangbusters, which is why I chose Caterpillar (NYSE:CAT) as my own top stock for 2012. The world’s biggest construction and mining equipment manufacturer has gained more than 25% so far this year.

The flip side of sector rotation is that as the market embraces risk, defensive sectors lag. That means they deserve an underweighted portion of a tactically allocated portfolio. The heavy-dividend-paying, highly defensive sectors of utilities and telecommunications are posting losses so far this year. Utilities are off 3.8%, while telecoms are down 2%, according to S&P.

The other classically defensive sectors of consumer staples and health care are also delivering subpar returns. The consumer staples sector is essentially flat on the year, while health care is lagging the broader market by about 4 percentage points.

Investors looking to make the most of the risk-on trade would do well to overweight tech, financials, basic materials and industrial stocks — either through exchange-traded funds or liquid, large-cap names like Apple, Bank of America, Microsoft, Alcoa and Caterpillar.

At the same time, underweight defensive sectors and stocks, which will act like bonds — providing ballast to your portfolio — if and when the pause, consolidation or correction comes. If you’re bullish and can wait out any short-term sell-off in stocks along the way, “risk-on” allocation will ultimately generate superior returns.


Article printed from InvestorPlace Media, https://investorplace.com/2012/02/how-to-find-reward-in-riskier-sectors/.

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