What's Next for the Market's Top Performers?

Even though 2010 started out on a down note, it has not proven to be the end of the world. Economic news has been getting better, and concerns about the recovery being unsustainable are beginning to look more and more silly.

So far this year, the action has been concentrated in the economically cyclical sectors of consumer discretionary stocks, industrials, and financial stocks. According to a recent Goldman Sachs report, most fund managers have been surprised by the magnitude of the continuing rally this year and haven't capitalized on all of the market's gains. While the S&P 500 returned 5.4% in the first quarter, most large mutual funds returned 4.6%; hedge funds did even worse, returning 2%. The report notes that a large underweighting in consumer discretionary stocks, which rose 14% in the quarter, caused much of the shortfall.

Is there more room for consumer discretionary stocks?
These stocks typically lead an economic recovery. This is because they generally provide goods and services that consumers can do without -- hence the discretionary label. During recessions, consumers give up these items; but when the recovery comes, they release pent-up demand by increasing their discretionary spending. That gives consumer discretionary stocks a bigger lift than consumer staples, which consumers need even in tough times and which therefore offer smoother demand throughout the economic cycle.

Even as the recovery takes hold, however, I expect this relentless rally to slow down. As I see it, 2009 was more like 2003: In both years, the market bottomed out in March and began a powerful rebound. This year is likely to be more like 2004, which had a good start, but was a more range-bound year overall. The market generally rallies the most as the economic recovery is barely starting, as in 2009. By now there is no doubt that the economic data is improving noticeably.

In a recovering economy, it is only normal to look for outperformers in cyclical sectors, and consumer discretionary stocks still fit the bill to a T. Consider Disney (NYSE: DIS  ) , the ultimate consumer stock. The company operates movie studios, media networks, resorts, cruise lines, and all kinds of businesses that suffer first when consumers cut back on spending. Incidentally, those are the first to recover when consumers begin to spend. Yet even though the stock has nearly doubled in the past year, Disney is still trading at about 16 times forward earnings -- and earnings could grow substantially if this economy continues to surprise to the upside. To me, that makes Disney attractive.

Lowe's (NYSE: LOW  ) has also been on fire, having risen 20% in the past two months. The home improvement retailer is a clear beneficiary of a pickup in consumer spending as well as a recovery in such a depressed sector -- housing. For a long time, Lowe's used to be the cheaper of the two main home improvement chains, but that discount is now gone. The stock is also trading near 16 times forward earnings. Net income has shrunk by nearly 40% from 2008, so clearly there is huge room for improvement. If Lowe's can start growing its top line again, then it could get a huge boost to profits.

Back to industrials
Industrial stocks should also benefit from an ongoing recovery. The biggest component of the Industrials Select SPDR at 12.5%, General Electric (NYSE: GE  ) , has been on a tear since last summer. Its top spot in the SPDR exchange-traded fund is a little misleading because the company derives a huge chunk of its revenue from financial operations -- but financials have also been doing well this year.

Other classic industrials are doing well. 3M (NYSE: MMM  ) is a classic diversified industrial company with innovative culture and good margins. The company has a return on equity of 28% and operating margins of 22%. The stock is fairly valued, and although management has been criticized in the past for having a dividend of only 2.5%, the stock has been one of the better industrials to hold over the past year.

Among traditional cyclicals are heavy-equipment makers Caterpillar (NYSE: CAT  ) and Deere (NYSE: DE  ) . Both stocks are highly economically sensitive because they make expensive products, and their customers can typically postpone purchases in a difficult economy. Caterpillar's revenues fell 37% in 2009, but it now appears that they are rebounding, with analysts expecting 13% growth in 2010. Deere's sales also dropped substantially, though the market for agricultural commodities isn't quite as cyclical as the construction and mining industries in which Caterpillar's equipment is used.

One rule of thumb is that the more cyclical the industry, the less debt a company should carry. As a result, I don't like the fact that Deere has $25 billion in total debt, which is almost as much as its market cap. But the company does have a great brand name and room for growth in emerging markets, and so I think that makes the stock worth the risk.

The most economically sensitive stocks in the most economically sensitive sectors are doing the best. Even as experts debate the issue, the market is saying loud and clear that this recovery has staying power.

Nobel Prize winner Paul Krugman has an impressive pedigree, but does he really know what's going on? Find out why this economics Nobel Laureate may be wrong.

Fool contributor Ivan Martchev does not own shares in any of the companies in this story. Walt Disney, Lowe's, and 3M are Motley Fool Inside Value recommendations. Walt Disney is a Stock Advisor pick. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.


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