Sector Allocation Today

So you think the recovery is on the way, everyone is talking about. So you want to get on the best growth opportunities, assuming recovery is finally here.

Let’s assume for the moment that the recovery is here, then how does a prudent investor participate. My mantra is always to avoid individual stock risk and focus on the bigger picture. The bigger picture is and always will be the economic cycles. The economic cycles manifest itself in the stock market through sectors, or top ten S&P 500 GICS, represented by XLB, XLE, XLF, XLI, XLK, XLP, XLU, XLV and XLY.

Here are the latest numbers for Earnings per Share for each sector, sorted by highest 2Q11 EPS estimate:

Earnings per Share		Actual	Estimate
Ticker	Sector	1Q11	2Q11
XLB	Materials	35.2%	44.1%
XLE	Energy	24.3%	20.7%
XLF	Financials	12.0%	19.1%
XLI	Industrials	24.3%	14.1%
XLK	Technology	18.2%	12.5%
XLY	Consumer Discretionary	10.7%	12.1%
XLP	Consumer Staples	7.5%	10.3%
XLV	Healthcare	2.0%	3.6%
XLU	Utilities	-3.9%	-4.7%
Sources: Barron’s, Thompson Reuters

 

Now let’s think about these numbers and understand what they tell us. If you look at the sectors with the highest EPS projections, the sectors that are typically associated with recovery do come on top, such as Materials, Energy, Financials and Industrials. This actually makes sense — during the economic recovery cycle, we build more, and hence consume more energy, have higher financial activity and invest into capital projects. So on the surface it makes sense to buy these sectors. OK, we are done, let’s buy.

Not so fast!

Here is another take on these numbers. Let’s look at things through a different lens, here are the EPS for each sector, but I added EPS growth, Quarter on Quarter:

Earnings per Share		Actual	Estimate
Ticker	Sector	1Q11	2Q11	Growth
XLV	Healthcare	2.0%	3.6%	80.0%
XLF	Financials	12.0%	19.1%	59.2%
XLP	Consumer Staples	7.5%	10.3%	37.3%
XLB	Materials	35.2%	44.1%	25.3%
XLY	Consumer Discretionary	10.7%	12.1%	13.1%
XLE	Energy	24.3%	20.7%	-14.8%
XLU	Utilities	-3.9%	-4.7%	-20.5%
XLK	Technology	18.2%	12.5%	-31.3%
XLI	Industrials	24.3%	14.1%	-42.0%

 

This picture tells us a completely different story. The top growing sectors are Healthcare, Financials and Consumer Staples. What does this mean? How come we have the same data, but this analysis paints a different picture.

In my opinion, the first analysis is a backward looking one showing a shorter term trend, while the second analysis is a forward looking one showing a longer term trend. Let me explain.

In the first analysis, the growth of sectors associated with recovery is based on the most recent short term mini cycle. In this mini cycle we do see some signs of recovery. This is based mostly on the past year’s data. On the other hand, the second analysis shows a longer term trend of the slow, but steady recovery of two sectors that have been “unfairly” beat up. Both the Health Care and Financials are still absorbing the regulatory shocks. As I mentioned in pervious articles, longer term, Health Care has a lot to give us. While the Financials, flush with cash, and mostly rid of bad debt, with lower competitive pressures are poised for long term growth.

So if you are looking to invest for the next month or two, go ahead, go for Materials, Energy and Industrials. This will probably bring you decent returns, but with a strong potential for the downside. If on the other hand you are looking for longer, steady growth, with lower risk I would strongly suggest you look at Health Care and Financials sectors.