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You've heard the news: The recession's over. So if you've been waiting for the all-clear before committing your cash to the stock market, you finally have to find an answer to the question that's been nagging you for months: Where's the right place to look for the best investments now?
Making a macro bet
Fidelity's research arm released an interesting study last month about how the stock market reacts to changing economic conditions. Specifically, Fidelity looked at various sectors of the market and tried to tie their performance to particular periods within a typical business cycle.
Before getting into the study, some background may be helpful. Economists break a typical business cycle into four different phases. In the recovery phase, the economy reverses course from a past slowdown and starts to grow at a faster pace. That then leads to a boom phase, where the most rapid growth occurs. Eventually, economic growth tops out and starts to slow again, leading to the slowdown phase. Finally, when growth stops and the economy contracts, we enter a recession, which lasts until the next recovery phase begins.
For the overall market, the study has some bad news: As a leading indicator of economic growth, stocks perform best in the period immediately after a recession ends. In hindsight, that's certainly consistent with the huge market rally we saw from March 2009 until earlier this year -- especially now that economists have set the end of the recession at June 2009. But as the economic expansion gets further along, average returns get slimmer. In other words, if the recession has really been over for more than a year and history proves out, investors may already have seen most of the gains they'll see before the next recession hits.
But before you conclude that it's too late to invest now, don't give up: There's evidence that some sectors do better during different phases of the business cycle. In particular, the study shows that if we're about to enter the boom phase, where the modest growth of the recovery phase builds up more steam, then energy and materials stocks provide the best returns. In contrast, rate-sensitive utilities and telecom stocks tend to do badly as interest rates begin to rise.
To test this theory, I looked back to the beginning of 2003, a bit more than a year after the National Bureau of Economic Research declared the last recession's end in November 2001. I then looked to see how members of the S&P 100 index performed between then and mid-2004, when the Federal Reserve finally started raising interest rates.
I found a fair amount of support for the study's findings. Among the top performers, gas pipeline operator Williams Companies (NYSE: WMB ) topped the list with a 344% return, and fertilizer giant Monsanto (NYSE: MON ) and miner Freeport-McMoRan Copper & Gold (NYSE: FCX ) both more than doubled during the 18-month time frame. Yet the sector relationships weren't perfect; stocks in many other areas, including technology and industrials, were also fairly represented near the top.
More generally, though, the relationships seem to hold reasonably true. Several other members of the energy sector, including Occidental Petroleum, Halliburton (NYSE: HAL ) , and ConocoPhillips (NYSE: COP ) , made it into the top 25, as increasing economic activity spurred higher energy use. And conversely, telecoms AT&T (NYSE: T ) and Verizon (NYSE: VZ ) were among the few stocks that posted a loss for the period, in part because faster growth made more aggressive investments more attractive.
Whether those trends will hold true this time around remains to be seen. Exchange-traded funds covering the energy and materials sectors have underperformed the broader market recently, while telecoms have done particularly well, and so a reversal of fortune on both counts would make intuitive sense if cycles are reliable.
Place your bets
That last point is the stickler. At this point, it's hard to tell exactly where in the business cycle we are. With many calling for a double-dip recession or worse, this period of purported economic expansion could be over almost before it's begun.
Yet the scariest thing to hear is the assertion that this time is different. Until the double-dip comes to pass, investing for a nascent recovery and looking especially at neglected sectors like materials and energy is the right way for reluctant investors to get back into the market.
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