This article is part of our Rising Star Portfolios series.
Many analysts look at a particular company and assess the fundamentals of the business before making a purchase decision. Although I definitely utilize this approach, sometimes I start in the opposite direction, analyzing economic and market conditions, choosing a sector or industry I like, and then I drill down on a specific company. This is commonly referred to as top-down investing.
In this article, I'll explain what economic cycle I think we're in and provide you with four stocks that can take advantage of the current environment.
Is this recession really over?
According to a recent report by Fidelity, there are four equity market phases:
- Recession phase: This obviously marks the beginning of a recession where equity returns are negative.
- Early-cycle phase: This begins prior to the end of a recession as investors anticipate a recovery; historically, the stock market returns about 32%, on average.
- Mid-cycle phase: This starts to kick-in when investors feel the Fed will hike interest rates to stave off inflation; typically the market returns 11%, on average.
- Late-cycle Phase: This phase begins when investors think that another slowdown is ahead and that the current recovery has run its course; the market accordingly has been flat during this period.
Normally it would be quite obvious that we're in the mid-cycle phase; the massive boom in the stock market during 2009 and the anticipation of an interest rate hike are almost sure signals. However, this economic cycle is a bit different than ones in the past because of the Fed's hesitancy to raise rates, according to the uncertainty of the recovery.
Could this be a double-dip recession? Is the last month's recovery a signal that we're out of the woods? I'm not an economist, but it seems as though we're somewhere between a mid- and late-cycle phase.
The three sectors that have consistently outperformed during these economic troughs, from 1963-2010, include energy, materials, and industrials. To gain broad and diversified exposure to one of these sectors you could look toward the Energy Select Sector SPDR (XLE) or the Materials Select Sector SPDR (XLB). Both of these ETFs have outperformed the broad market over the past three months; however, let's take a quick glance at the current earnings season to see if there's anything that can support my thesis further.
So where's the proof?
Not to ignore the fact that this year has been a complete roller coaster ride, but the third quarter has prompted some positive sentiment. Certain economic indicators such as existing-home sales and manufacturing activity have picked up, causing investors to take to metals like copper, aluminum, and of course, gold. Freeport-McMoran (NYSE: FCX ) , for instance, saw a 27% increase in earnings and an impressive 24% boost in sales. Construction and mining equipment giant Caterpillar (NYSE: CAT ) also reported impressive third-quarter numbers, with its CEO stating that he expects "positive economic growth." Caterpillar also boosted its outlook for the remainder of 2010 and expects the same for 2011. Even shares of Cliffs Natural Resources (NYSE: CLF ) are up on the month, after analysts rumored that the company may be preparing to purchase Massey Energy in an attempt to expand its Appalachian coal development.
It seems as though the energy and materials sectors are spouting off great numbers this earnings season, and in order to take advantage of that trend, I've identified four stocks worth looking into.
- ExxonMobil (NYSE: XOM ) : Energy producers such as Exxon have been working to increase production as a result of higher oil and natural gas prices. During the third quarter, oil prices increased to $76 per barrel, as opposed to $68 from the year-ago period. Exxon should benefit greatly; and even better, this stalwart is trading for only 10 times next year's earnings, way below its historical five-year average.
- Noble (NYSE: NE ) : This offshore driller has been severely affected by the Gulf disaster and the resulting moratorium, but the worst may be behind it. The company recently reported a decrease in earnings and a 33% drop in revenues, but the direst news may already be priced into the stock. Eventually, oil companies are going to return to the Gulf, and when they do, Noble will be there with fleets ready to roll. Right now may be the time to pick up shares as they are still down 15% on the year.
- Nucor (NYSE: NUE ) : In my opinion, Nucor stands out as the premiere steel producer in the U.S. Despite low GDP and high unemployment, it consistently delivers a return on equity near the top of the industry and pays a solid 3.8% dividend. When global demand eventually picks up, Nucor will be able to capitalize on the trend, as it has some of the most efficient and productive steel mills in the world.
- U.S. Steel (NYSE: X ) : Steel production and capacity has been down as of late, but this is a cyclical industry, and so now may be the time to jump on the train before other investors do. The company pumps out steel for almost every type of product -- automobiles, appliances, construction -- so an economic turnaround may be just what the doctor ordered for this mid-cap.
What I'm buying
Each of these stocks offer their own set of opportunities, but in the next two weeks, I'll be pulling the trigger on one and buying shares for my real-money Motley Fool Rising Star Portfolio. Stay tuned to read the next article and find out which stock is going to make it past the initial due diligence and into my portfolio!
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