The Case for Rotating into (Select) Cyclical Sectors

by on June 24, 2013 | ETFs Mentioned:

As it turned out, the most recent Great (Sector) Rotation was short lived and perhaps not so great after all.

But although defensive sectors are back to outperforming cyclical sectors amid June market volatility, I still believe there’s a strong case for preferring cyclicals over defensives, or at least select cyclicals [see The Cheapest ETF for Every Investment Objective].

There are three reasons to consider investing in cyclical sectors now.

1. Attractive Valuations. Defensive sectors continue to look overpriced. Investors searching for safety and yield have driven up the valuations of defensive companies. The three classic defensive sectors – healthcare, staples and utilities – are now trading at an average premium of around 20% to the broader market. By way of comparison, back in the fall of 2009, these three sectors were trading at an average discount of around 40% to the broader market. Current premiums seem unjustified considering that profitability is somewhat lower for companies in the defensive space [also see 7 Cyclical Industry ETFs You Need To Own In This Bull Market].

ishares 6.242. Exposure to Emerging Markets. Second, cyclical sectors, particularly technology and industrials, generally have more exposure to emerging market growth than their defensive counterparts. This means that they’re a good way to access my preference for emerging markets without actually investing directly in emerging markets themselves.

3. Current Relative Risk Levels. Although cyclical sectors have always been, and probably always will be, more risky (as measured by realized volatility) than defensive sectors, there are fluctuations in cyclical sectors’ riskiness relative to their defensive counterparts. Currently this relative risk is low when compared with its average level over the last five years. This is partly because defensive sectors have become riskier as investors have flocked to them. As more crowded trades, defensive sectors are potentially more sensitive to investor sentiment and could experience greater price volatility [see How To Take Advantage Of The Great (Sector) Rotation].

However, not all cyclical sectors are created equal. Here’s a ranking of how I believe the various cyclical sectors stack up, from the most attractive to the most expensive.

  1. Energy (most attractive)
  2. Information Technology
  3. Industrials
  4. Consumer Discretionary
  5. Financials
  6. Materials (least attractive)

The list above is based on my team’s analysis of whether sector valuations appropriately price in each sector’s expected earnings growth, profitability and risk.

Based on these factors, I have a preference for the energy and informational technology sectors, accessible through the iShares S&P Global Energy Sector Fund (IXC, A) and the iShares S&P Global Technology Sector Fund (IXN, B+). And as I write in my new Investment Directions commentary piece, if it turns out that we do see more investors rotating out of defensives and into more attractively priced cyclicals, these two sectors are poised to especially benefit.

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Source: Bloomberg, BlackRock Investment Strategy Group research

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

The author is long IXC

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments typically exhibit higher volatility. Technology companies may be subject to severe competition and product obsolescence.  The energy sector is cyclical and highly dependent on commodities prices. Companies in this sector may face civil liability from accidents and a risk of loss from terrorism and natural disasters. iS-10131-0613