STOCK WATCH


Stocks to Lead the Next Bull Market

Anne Kates Smith

Don't pin your hopes on the last one's leaders. This time look to the industrial and materials sectors and shares of small companies.



Okay, we get that you may be, to put it mildly, disenchanted with the stock market. But even in your darkest hours as an investor -- maybe precisely during your darkest hours as an investor -- it's not too early to start thinking about the next bull market and how you might want to invest in it.

The reason is that markets turn on a dime, and much of the gains are made early. The way the Leuthold Group, a Minneapolis investment-research firm, puts it, bull markets are front-loaded. Leuthold researchers have found that in the 22 bull markets since 1900, the Dow Jones industrial average has clocked a median first-year price gain of 41% -- nearly half of the median total bull-market gain of 84% (half the figures are above the median and half are below). On average, investors make back 82% of their bear-market losses in the first year of a bull market, according to Standard & Poor's.

Don't confuse economic pain with investment losses. As pundits rush to draw parallels between today's economic downturn and the Great Depression, it's worth noting that two of the fastest-rising bull markets in history occurred in the 1930s. Hard times are far from over, but the stock market typically anticipates the economy's condition by three to nine months, and some of what is shaping up down the road looks promising.

President-elect Obama wants to initiate a massive public-works project -- possibly on the order of $500 billion to $1 trillion -- to rebuild bridges and roads, modernize schools, and invest in energy efficiency and information technology. Meanwhile, gasoline has fallen from more than $4 a gallon to less than $2, and there's talk of long-term rates of 4% on mortgages -- a boon to cash-strapped consumers and wary home buyers.

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Some signs point to a tentative lifting of spirits already. Analysts are starting to revise more of their earnings estimates higher, at least as a percentage of total revisions -- although analysts are notorious for sometimes unfounded optimism. Still, a number of industry groups with positive stock performance in November (agriculture, brewers and construction, among others) suggest that investors are at least starting to shift money around in the stock market instead of bolting for the exits.

Another encouraging sign: There is plenty of money to fuel a rally. The ratio of near-cash investments -- including demand deposits and money-market funds -- to the total market value of the U.S. stock market is at an 18-year high, a level last seen in 1990. Money alone can't spark a rally -- buyers have to do that. But liquidity is the fuel that keeps rallies going.

Once you're committed -- no matter how grudgingly -- to the next bull market, the search is on for investments that will lead the way. There's no shortage of ideas on that front, but one thing is clear: Pinning hopes for the next bull market on the last one's leaders is a lot like showing up for an inaugural ball sporting the last administration's fashion statement. In other words, if you've been holding on to your battered portfolio, convinced you'll be vindicated, know that you'll have to do at least some rejiggering.

Consider this: Energy stocks may have made you a mint in the '70s, but they were at the bottom of the pack in the bull market that began in 1982. Tech stocks did not regain their supremacy after the dot-com meltdown at the turn of the century. Former leaders tend to be retired, either because their fastest-growing days are behind them or because excesses that felled their bull market will weigh them down for years. So for anyone waiting on a broad-based comeback in financials, we have one word: fuggedaboudit.

In terms of investment styles, stocks of small companies, particularly those growing at a good clip, historically have had the edge at the dawn of new bull markets, and many people think there's a good case building for the little guys in 2009. In bull markets since the Great Depression, small-capitalization stocks have rallied more than 50% on average from the bottoms they hit mid recession.

In fact, they've logged an average gain of 44% in years during which the economy has been flat or has contracted up to two percentage points, according to data from Citigroup Global Markets. It doesn't hurt the case that price-earnings ratios on small- and mid-cap stocks have fallen to the lowest level in nearly two decades.

Citigroup is favorably disposed to small fry that cater to consumers and information-technology companies. Among the names its analysts likes: cable and broadband provider Charter Communications (symbol CHTR, $0.12), weight-loss company NutriSystem (NTRI, $13.01), Veeco Instruments (VECO, $6.29), which makes equipment for semiconductor manufacturers, and Bankrate Inc. (RATE, $32.94), a publisher of information on interest rates and consumer banking. If you'd prefer to invest through an exchange-traded fund, good choices include Vanguard Small Cap (VB) and iShares Russell 2000 Index (IWM). (All share prices are as of the December 15 close.)

When you ponder which market sectors or industry groups to explore, it helps to remember the truism that every dog has its day, and vice versa. Chances are, the defensive groups holding their own now will stop working once the bear market bottoms. That means consumer staples -- the companies that make things we buy no matter what -- and utilities could stagnate even as the rest of the market recovers. The reversal this go-around could be more dramatic than what is typical because the rush to defensive sectors -- just look at gold and Treasury bonds -- has been so frenzied.

Historically, sectors that work best in new bull markets are the ones most downtrodden in the early parts of a recession, including consumer-discretionary stocks -- those of companies that make big-ticket and luxury items, or other items we can postpone buying -- and technology stocks and financials.

Those categories show precisely why history is a guide but never gospel, says Sam Stovall, chief investment strategist at S&P. Take financials. Many people bought into them thinking the stocks had hit a low in March, then again in July, and yet again in September. That set up a lot of what technical analysts call "overhead resistance." Stovall's translation: "When all these people get back to break-even, they'll say 'thank goodness,' dump the dog, and move on." Similarly, it may be hard for consumer-discretionary stocks to go beyond an initial surge because of investor worries over the ability -- and willingness -- of consumers to increase their spending.

But stocks in the industrial and materials sectors, also traditionally among the leaders in nascent bull markets, are good bets for assuming the mantle again this time. They may have already done so, thanks to a concerted push to turbocharge economies around the globe, says investment strategist Ed Yardeni, of Yardeni Research. "Central banks and governments around the world are responding to the global recession by slashing interest rates and announcing big spending programs, especially on infrastructure," he said in a note to clients on December 9. From the market's bottom on November 20 to that date, steel stocks advanced 62%, compared with a 21% gain in Standard & Poor's 500-stock index.

High-quality stocks worth a look include construction-supplies company Fastenal (FAST, $32.23); Fluor, a provider of construction and engineering services (FLR, $48.08); Cummins (CMI, $24.03), a maker of engines and electric power-generating systems; and steel producer Gerdau AmeriSteel (GNA, $5.72).




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