Winners in the next bull market

Business Times - 22 Jul 2009

The stocks that fare best are found in economically cyclical areas such as the tech, financial services and consumer sectors

(NEW YORK) WHICH investments are most likely to perform best in a bull market? Many investors have turned bullish in recent months, and, based on the stock mutual funds that they're choosing, they evidently think they know the answer.

Since Jan 1, nearly US$30 billion of net new money has poured into funds that invest in speculative emerging-market stocks. In that same period, investors have pulled money out of stock funds focused on the domestic market and developed foreign markets.

At first blush, moving money into emerging markets may seem a smart bet. Since stocks began to rebound in early March, the MSCI Emerging Markets index has soared 63 per cent, compared with a 39 per cent climb for the Standard & Poor's 500 index of domestic shares.

There's just one problem: History shows that asset classes that perform best in one bull market - as emerging-market stocks did in the run-up from 2003 to 2007 - rarely repeat that feat in the next. For example, the foreign-stock boom of the late 1980s gave way, after a brief bear market in 1990, to big gains in financial stocks in the early 90s and then to the surge in technology stocks in the middle to late part of the decade.

Deceptive

Of course, nothing is certain in investing. And emerging-market stocks could wind up bucking historical patterns. Still, market watchers say that it's dangerous to base an investment strategy for an extended bull run on early-stage results. In fact, stocks' behaviour in the first two to five months after a bear market can be quite deceiving. That's because a pattern tends to emerge when the market transitions from bull to bear back to bull again.

James Stack, editor of the InvesTech Market Analyst newsletter, notes that the stocks that tend to lose the most in a bear market are the best performers in the previous bull market. 'But then, coming out of those downturns, very often you'll see those same sectors regain their leadership status,' simply because they fell the most, he said. 'The question is, will that continue? In many cases, it will not.' Consider the last bull-to-bear-to-bull transition. Technology shares were the market's darlings in the late 1990s, during the Internet stock bubble. But after crashing the hardest in the bear market of 2000 to 2002, tech shares looked as if they would pick up where they left off.

In October and November 2002, the first months after that bear market, tech stocks far outpaced the market overall. Tech shares in the S&P 500 gained nearly 43 per cent in less than two months, while the index itself rose a more modest 15 per cent. Yet the tech resurgence proved to be short-lived, as the sector lagged behind the broad market through much of the bull-market period of 2004 to 2006. 'Due to their bear market losses, technology stocks had an easy time rebounding,' Mr Stack noted. 'The problem is, moving forward, considerations like valuation take over. And that's likely what we'll see in this market.'

Already, market strategists are becoming concerned that the emerging-market rally that began in March has gotten ahead of the fundamentals. The MSCI Emerging Markets index, for example, trades at a price-to-earnings ratio of 16.1, which is 25 per cent higher than its average P/E over the last five years.

'I don't think you want to be joining the emerging- markets bandwagon right now,' said Sam Stovall, chief investment strategist at S&P. 'They're trading at valuations that aren't cheap anymore.'

So if emerging markets aren't likely to provide the best returns, which sectors will? The answer will depend largely on what type of recovery is ahead, said Gordon Fowler Jr, chief investment officer at Glenmede, an investment firm in Philadelphia. For example, if a speedy economic rebound is in store, a bet on economically sensitive investments - such as financial shares and emerging-market stocks - could make sense.

But on the other hand, Mr Fowler said, if you believe that even after a recovery, 'the economy will be weak over a sustained period of time and is not going to be driven by American consumption, then I think that leads you to a different group of companies - good growth companies with solid balance sheets'.

And that search would lead investors to two asset classes that led the bull market of the late 1990s: large blue-chip growth stocks, which Mr Fowler says are at reasonably attractive prices, and tech shares, which stand to benefit whether a global recovery is weak or strong. Mr Fowler points out that 'after the last downturn, technology companies got religion and repaired their balance sheets'. In fact, tech companies in the S&P 500 now hold more cash relative to their overall assets than any other sector in the market.

Mr Stovall agrees that tech is likely to be one of the best performers of the next bull market. Historically, he notes, the stocks that fare best in a new bull market are found in economically cyclical areas, which would lead investors to the tech, financial services and consumer discretionary sectors. But given the continuing uncertainty about the health of financial companies and consumer spending in general, he says tech is likely to be the best bet. -- NYT