Moving From the Defensive

 | Apr 23, 2013 | 10:15 AM EDT
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As the year has unfolded the market has been moving away from more economically-sensitive and appreciated-oriented stocks, industries and sectors. While the year started on a strong note, with many of these companies playing catch-up after having lagged during the past couple of years, more recently they have faded, as investors have continued to seek the comfort of more defensive sectors.

It has been a year where once again there has been a bias towards more defensive and dividend-oriented sectors such as healthcare, consumer staples, utilities and telecom, at the expense of materials, industrials, energy and technology stocks. 

The question is whether 2013 will end up being a reprise of 2011 and 2012, in which more defensive sectors, industries and stocks held sway, or whether the current state of affairs is shorter term in nature, where market leadership will revert back to more economically sensitive stocks.

In our view, 2013 will not be a repeat of the two previous years. We do not think that defensive stocks and sectors will lead the market over the balance of the year. Rather, we expect leadership to rotate to more economically-sensitive and appreciation-oriented market sectors.

Unlike the past few years, there is no overarching fear about the direction of the U.S. economy. While growth is slow, the continued resurgence of housing and the strength of corporate earnings have strengthened the conviction that the U.S. is in a sustainable, slow-growth recovery mode.

Given such an underlying sense of things, fundamental and valuation considerations become more important, and we think that argue strongly for a slowdown in some of the recent leaders and a catch up for the laggards.

Basically, the more recently favored sectors are chock-a-block with fairly, fully and overvalued names. What utilities and consumer staples have going for them is their attractive dividend yields, but P/E multiples in many cases are at the upper end of their historical ranges. It seems likely that, absent a macro-induced shock, future growth is likely to more closely track earnings and dividend growth.

In the case of healthcare stocks, many pharmaceuticals have benefited from their slow and steady earnings growth coupled with their healthy dividends.  But from here we think there are a lot of uncertainties related to the implications of Obamacare and the group's future gains are likely to slow.

Conversely, there are numerous bargains to be found among the more recently under-favored sectors. While recent earnings have been somewhat sluggish, many companies are predicting second half upturns. In the meantime, dividends are becoming increasingly attractive among these sectors as well, a factor which should start to entice bargain hunters. Select technology, energy and industrials should be poised for solid gains as the year progress.

One other sector that we have liked, financials, have had favorable earnings growth but has performed in the middle of the pack for the year-to-date stock performance, including the recent pull back. We believe that financials offer considerable stock price upside as they continue to return to more normalized valuations with the 2008/2009 financial crisis fading further into the past. We believe financials'stock prices should be aided by their healthy and growing dividends, and think that this sector is likely to be among the biggest beneficiaries as the market's confidence improves.

Stocks that would benefit from the above outlook, and which also offer attractive dividend payouts, include Cisco (CSCO), Emerson Electric (EMR), General Electric (GE), Occidental Petroleum (OXY), Royal Dutch Shell (RDS.B), and Wells Fargo (WFC). Each offers great franchise strength, good prospects and attractive to compelling valuations, including a rising dividend stream.

Bottom line, we believe that the stock market will enjoy a good 2013, and should see leadership revert to those sectors that more typically excel in such market environments. Defensive names should fade from their current top of the perch position as investors seek to invest in well-priced, quality companies offering better appreciation prospects.

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