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Defensive stocks have fallen out of favour the past few months and being replaced with financial, energy and tech stocks. (iStockphoto/iStockphoto)
Defensive stocks have fallen out of favour the past few months and being replaced with financial, energy and tech stocks. (iStockphoto/iStockphoto)

Four stocks to buy as cyclicals take market leadership Add to ...

John Reese is chief executive officer of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.

The shift in U.S. markets toward stocks of companies that are more sensitive to economic growth is sending a mixed message to investors.

On the one hand, uncertainty about growth and also the U.S. presidential election in November should argue in favour of investors continuing to embrace the defensive stocks in the utility and telecommunication sectors they favoured earlier in the year. But it’s clear, based on the past few months in the market, those stocks are falling out of favour and being replaced with financials, energy and technology stocks.

If economic growth comes through better than expected between October and into next year, these higher beta stocks seem well positioned to gain. However, it is also the case that they are relatively less expensive. So, whether investors are sending a clear message on growth remains to be seen.

Investors have been hunting for yield for many months now, but in the equity market rather than in bonds. They drove up dividend-paying utilities and telecommunications stocks earlier this year, with some fearing the stocks had got overheated.

But the flood of money switching from defensive to cyclical stocks has gained since July. The Powershares high-beta exchange traded fund, which tracks an index of stocks that are sensitive to economic growth trends, is up 14.42 per cent year to date, and up 14.66 per cent in the past three months. Contrast that with the 7.02-per-cent year-to-date gain in the corresponding low-beta ETF, which tracks so-called defensive stocks, the kind that pay dividends and aren’t as affected by volatility. The low-beta ETF is down 5.05 per cent in the past three months.

Specifically, the iShares ETF tracking information technology is up 14.5 per cent since July, while the one tracking financials is up 6.7 per cent. And the utilities ETF is down 10.1 per cent since then.

The broad market ETF is up 7.48 per cent year to date and up 3.45 per cent in the past three months.

The shift to cyclical stocks comes as corporate earnings for S&P 500 companies are falling, expected to decline 2.1 per cent for the third quarter, the first time the index has had six consecutive quarterly declines since the data company FactSet started tracking it in 2008.

Another variable in the equation is the U.S. Federal Reserve and interest rates. Most observers expect the Fed to raise rates in the coming months. The increasing of rates would be interpreted by the market as indicating that growth and the economic outlook are good. The beneficiaries of rising rates would be energy, technology and industrial stocks, which tend to correlate to interest-rate moves since growth encourages capital spending and development.

The energy sector is already rebounding from last year’s slump despite persistent low commodity prices. And shares of financial companies could get a boost on improved profit margins for lenders, insurers and others with an uptick in rates.

The investor Peter Lynch, who steered Fidelity Investment’s Magellan mutual fund to a 29.2-per-cent average annual return from 1977 to 1990, favoured stocks of companies that were known quantities. Cyclical companies tend either to sell expensive products themselves or to make expensive parts for others to sell, he used to say. Consumers don’t buy expensive products when times are bad.

That leads us to another Lynch saying: “Unless you’re a short seller or a poet looking for a wealthy spouse, it never pays to be pessimistic.”

Taking all this into account, I recently culled my database for some of the top-scoring names that look good fundamentally and would be set to benefit as cyclical-like stocks take a leadership role in the market.

  • HP INC (HPQ) – The maker of personal computers, imaging and printing machines and other gadgets stands to benefit on a pickup in technology spending. It has a strong cash position and makes for a good momentum play, as its relative strength trend has been increasing over the past four months. The stock gets 100 per cent based on the Joel Grenblatt Magic formula strategy and the James O’Shaughnessy Cornerstone Value approach.
  • Hooker Furniture (HOFT) – This home furnishing and design retailer falls under the “super stock” criteria of Kenneth Fisher, who likes to compare a stock’s price to the company’s sales as a barometer of health. Stocks that fall below a ratio of 1 are considered good values, and Hooker Furniture's ratio is 0.75.
  • Fossil Group (FOSL) – This maker of popular consumer fashion accessories recently introduced a second generation of its smart watch, a growth market in the consumer gadget category. The stock fits the strategy of value investor Benjamin Graham 100 per cent, with solid financials and a rock-bottom valuation.
  • Robert Half International (RHI) – The staffing and human resources provider is poised to benefit from favourable job and hiring trends. The stock would be considered a “fast grower” under the Peter Lynch model, with an earnings growth rate of 30.6 per cent while its price-to-earnings ratio is 13.5, thus making the PEG ratio a very favourable 0.44.
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