It's Time to Buy Cyclical Stocks -- Here's Why

Lulled by the rhythm of recurring record highs for the S&P 500 (SNPINDEX: ^GSPC  ) and Dow Jones Industrial Average (DJINDICES: ^DJI  ) , there is the risk that some investors will be seduced by bubble-logic. Oaktree's Howard Marks eloquently captured this thinking at the Milken Institute's Global Conference last week, noting:

People ignored the cyclicality of things [during the credit bubble]. They thought trees would grow to the sky. They believed in permanent good times.

Cyclicals at a 15-year low
Thankfully, such behavior is not widespread right now. In fact, as I pointed out only last Friday, the current stock market rally appears to be one of
the most mistrusted on record. Still, investors should always pay attention to cyclicality, particularly when it appears to have reached an extreme -- because it is a probable source for huge opportunity -- or risk (and often both.)

Today, cyclicality appears to have reached an advanced stage with regard to, well, cyclical stocks -- or, more precisely, with regard to the relationship between cyclical and defensive stocks. According to broker Goldman Sachs, cyclical stocks have hit a 15-year low in terms of their valuations relative to those of defensive stocks.

I was unable to validate Goldman's claim for lack of data, but I did manage to produce some results suggesting that investors' preference for defensive issues has opened up a valuation gap between the two groups. Consider the following data:


P/E: Percentile From Market Low of March 9, 2009 to Present (average*)

S&P 500 defensive stocks (consumer staples, health care, telecom services, and utilities)

84th percentile

S&P 500 cyclical stocks (energy, industrials, materials, and financials)

62nd percentile

Source: Author's calculations, based on data from S&P Capital IQ. *Weighted by market capitalization.

Those numbers show that over the period spanning back to the market's 2009 low, defensive stocks are, on average, significantly higher within their own valuation range than cyclical stocks.

Cyclicals will outperform
Goldman's conclusion? Cyclical stocks are poised to beat their defensive counterparts:

Assuming U.S. GDP growth can exhibit some signs of reacceleration during the second half of 2013, currently identical 2014 sales and earnings estimates mean investors can buy growth at a discount. Given the 4 P/E multiple point head start, even a slight valuation normalization should translate into outperformance of cyclicals versus defensives during the next 12 months.

Still, while a strategy of overweighting cyclicals looks favorable, investors must be patient. As Goldman warns:

Horizon matters because any rotation away from defensives may not happen immediately. Historical analysis indicates no specific timing for how long it may take for the relative valuation gap to close once it reaches an extreme such as one standard deviation from the long-term average.

The takeaway for stock pickers
If you're a stock picker, you needn't rejigger your entire portfolio on the basis of this recommendation. However, it may be useful to review the valuation of the defensive names you own. In looking for new buys, don't ignore cyclical sectors -- they're more likely to be a "target-rich environment," as Maverick would say.

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