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Cyclical Rebound?
Toronto: June 02, 2014
By John Stephenson

Heading into 2014, most strategists were touting the merits of cyclical stocks, which tend to outperform the broad market when global growth is improving.  But despite the cheerleading, professional investors are less exposed to cyclical stocks than at any time since the financial crisis of 2008/09.  With investors shunning cyclical stocks, valuations have fallen, with many subsectors trading below trend multiples.  And with the most recent installment of the U.S. ISM Manufacturing Index about to hit the tape on Monday morning, maybe now is the time to take a second look. 

American stocks ended another gravity defying week, closing at record highs, with the S&P 500 ending up 0.2 percent at 1,923—its fourth record close in five sessions.  Worries on Wall Street seem to be waning with the so called “fear gauge,” the CBOE VIX Volatility Index falling 1.5 percent this past week, to hover near its 2014 low.  Yet despite this very positive market backdrop, cyclical stocks have performed relatively poorly in recent months. 

But the bond market seems to be signaling something different, with bond investors shifting toward safe havens, notably U.S. Treasury bonds, a preference that suggests that economic growth may begin to falter.  This is also part of a global trend, with the yields on the government bonds of Britain, Germany and Japan continuing to fall.  And falling bond yields pose a conundrum for the U.S. Federal Reserve, whose policies depend on the economy growing with less Fed support.

Despite the warning signs from the bond market, stocks appear poised to outperform for the balance of 2014.  Low bond yields and interests rates help the economy and together with a Fed that is still supportive of economic growth, this is a potential goldilocks scenario, where both stocks and bonds can continue to soar. Yet some bond market observers are quick to point out that the surge in bond prices has nothing to do with the economy but rather, market momentum. 

Bonds have surged for many reasons, but not because bond investors are worried about the health of the U.S. economy.  Bonds have rallied as demand has surged from pension funds and insurance companies and by a shortage of longer-term bonds.  Low interest rates in Europe and Japan have helped push international investors toward U.S. Treasuries, while China is said to be buying Treasuries to help weaken its currency against the U.S. dollar.  As well, hot money traders that initially bet on rising bond yields, had to reverse course when their initial bets fizzled, driving yields lower still.

Falling bond yields are fueling a reach for yield, with some bond investors holding their noses and putting money in places they once avoided in a frantic search for better-yielding investments.  In Spain, Italy, Greece and developing countries, bond demand has risen, pushing yields down.  Spain’s benchmark government bond yielded just 2.85% last week, down from 5.06% last June while Greece was recently at 6.21%, down from 11.38% a year ago.

If U.S. economic growth continues to improve and it looks likely that it will, yields on bonds should turn higher, hurting anyone buying bonds at current levels.  But for stock investors, particularly those investors willing to pick away at cyclical stocks, the future looks decidedly brighter.  Within the cyclical sectors, Industrials represent one of the best combinations of strong fundamentals and positive leverage to the ISM and industrial production, which is still expanding at a decent pace.  An added bonus is that the sector is broad, allowing investors plenty of opportunity to diversify within the sector.  Other cyclical subsectors where valuation looks attractive are Tech, Media, Autos and Consumer Finance.

With valuations in many cyclical names trading well below their long-term multiples and with fund managers sitting on the sidelines, now might be a savvy time to begin your very own cyclical recovery.

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