These Five Sectors May Lead the Next Leg of the Rally

As Treasury yields topped 2 percent late last month, something curious happened in the equity market.

Stocks struggled, seesawing between losses and gains after rallying 18 percent in the first 4 ½ months of 2013. But a closer look reveals investors had already started shifting into underperforming industries, betting that faster economic growth would favor banks, machinery makers, luxury retailers and the like.

Defensive sectors including health care and consumer staples led the stock-market rally earlier this year. But, true to the historical pattern, economically sensitive stocks and sectors have rotated to the top of the leader board in May and June.

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Since March, four of the top-five-performing S&P 500 sectors are all cyclical, or those most closely tied to the economy. Financials (up 8 percent) are leading, followed by consumer discretionary (+6 percent), while technology (+4.6 percent) and industrials (+3.7 percent) round out the top five. Health care (+5.3 percent) is the only defensive industry still among the top five in performance.

Concerns over rising interest rates coincide with this sector rotation.

Bond yields have risen from record lows after Federal Reserve Chairman Ben Bernanke said three weeks ago that policymakers could taper an $85 billion-a-month stimulus program in the months ahead if the economy strengthens. Yields on the benchmark 10-Year Treasury jumped to 2.29 percent earlier this week, the highest in over a year.

Last week in Money and Markets, I pointed out that stock investors may have nothing to fear from rising interest rates — provided they increase for the right reasons. Namely, because a stronger economy will support higher sales and profits.

History Repeats

There is a historical precedent for cyclical sectors outperforming others during periods of rising interest rates.

Researchers at Birinyi Associates studied nine periods since 1962 when interest rates (measured by 10-Year Treasury yields) rose significantly and for a sustained period.

They found that stocks perform just fine early in a rising-rate environment, with the S&P 500 up a median 7.5 percent, on average, six months after yields begin to climb. Stocks were up 13.8 percent a year later, but there is a definite tilt toward cyclical-sector outperformance.

Cyclical sectors were consistently among the top-performing stock-market sectors, with technology leading the way, followed by industrials and basic materials. Each of these economically sensitive sectors outperformed the S&P 500 on average during the six months after interest rates started to increase. Technology gained 15.2 percent, on average, industrials advanced 11.5 percent and materials gained 10.3 percent.

Defensive sectors, on the other hand, were among the worst performers. Those included high-dividend payers, such as utility and telecom companies.

It may be a good idea to reevaluate your equity allocation and consider adding pro-cyclical sectors such as financials and technology.

Prepare for Rising Rates

All this brings us to the most crucial question for investors: Are your investments prepared for rising rates?

Reevaluate your equity allocation by sector and fixed-income investments. If you find yourself overloaded with utilities, telecom, consumer staples or other high-yielding stocks, you may want to consider shifting your asset allocation to a more balanced approach by adding pro-cyclical sectors and shares.

For example, in a simple ETF-based investment approach, you might consider adding to the Technology Sector SPDR ETF (XLK) or the Industrial Sector SPDR ETF (XLI).

Cyclical stocks and ETFs may not only protect you as rates climb, but they may become the new leaders in the next leg higher for the equity market.

Good investing,

Mike Burnick

Mike Burnick, with 30 years of professional investment experience, is the Executive Director for The Edelson Institute, where he is the editor of Real Wealth Report, Gold Mining Millionaire, and E-Wave Trader. Mike has been a Registered Investment Adviser and portfolio manager responsible for the day-to-day operations of a mutual fund. He also served as Director of Research for Weiss Capital Management, where he assisted with trading and asset-allocation responsibilities for a $5 million ETF portfolio.