Stocks to Buy Before the Recovery

With stocks, as with so much else in life, itÕs better to be early than late. Share prices regularly anticipate economic recoveries, climbing off their lows six to nine months before the economy starts to improve.

If stocks behave as they usually do, get ready to make some money in the next few months. Based on the past ten recessions, all of which occurred after World War II, Standard & Poor's 500-stock index has gone up 32% one year after the market hits bottom during the economic downturn. (Although the U.S. is not yet officially in a recession, Kiplinger's believes we slipped into one late last year or early this year. And if the economy didn't enter into a recession then, the arrival of $4-a-gallon gasoline clinches the matter.)

The pattern of stocks beginning a powerful rise during a recession is so strong that it would be shortsighted not to take some spare cash and put it to work in a broad index fund or exchange-traded fund that tracks the largest U.S. companies. But what if you're more adventurous? Stock-market recoveries always include groups of companies that start to rise in advance and help persuade investors that the overall market is healing. Four sectors deserving a close look today are banks, retailers, heavy industry and technology.

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Banks. Banks and other financial institutions are sending mixed signals, one moment showing signs of health, the next raising questions about the value of the loans and mortgages they hold. But there's no question that the shares of good financial companies have been hammered along with those in serious trouble. Different kinds of financial companies benefit in different ways from a sounder economy, so Bill Rutherford, a wealth manager in Portland, Ore., suggests complementing a high-quality national bank with a more specialized investment-banking concern.

JPMorgan Chase (symbol JPM) is actually a little of each, but it's especially well regarded for its traditional banking business. Morningstar analyst Ryan Lentell believes that the takeover of Bear Stearns will increase Morgan's value to its shareholders and that its robust balance sheet enables it to make other acquisitions. The stock showed signs of life when it went up 36% in two months, to $49, on the news of the Bear Stearns deal. At $40 in mid June, the stock trades at 14 times estimated 2008 earnings of $2.91 a share.

Rutherford also favors Goldman Sachs (GS). For starters, Goldman missed the worst of the subprime-mortgage credit crisis. And besides investment banking, which picks up in an economic recovery, Goldman is also known for money management, a business that Wall Street values generously. Yet in the general disdain for big financial stocks, Goldman has taken its lumps. At $169, the stock has dropped by nearly one-third since last fall and trades at just 11 times estimated profits of $15.63 a share for the fiscal year that ends this November. That sounds like the price of an out-of-favor stock. But Goldman shares were also cheap throughout the economic expansion and bull market of 2003 through 2006 -- and they quadrupled.

To buy financials in one fell swoop, check out Vanguard Financials ETF (VFH). It invests in more than 500 of them. About one-fourth of the exchange-traded fund's assets are in small and midsize banks, which are still struggling, but it gives you the biggies, too, including Morgan and Goldman.

Retailers. Americans are spending less, so retailers' sales are down this year and earnings growth is rare. But better chains can benefit in hard times as weak and overextended competitors consolidate or shut down altogether. When the economy rebounds, the survivors will thrive.

Nordstrom (JWN) and J.C. Penney (JCP) are a fine double play on an eventual pickup in consumer spending. Penney has high hopes for American Living, a brand launched in February that spans clothing, accessories and housewares. Nordstrom's customers are wealthier than Penney's, although they, too, are paring back. To boost business, Nordstrom started a "click and mortar" service in May. You buy stuff online, then pick it up at any Nordstrom store.

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Nordstrom, at $34, and Penney, at $39, have roughly tracked the S&P 500 so far in 2008. That's not bad, but what you should know is this: After the recession of 2001 ended in November of that year, Nordstrom shares shot up 60% in six months. Penney didn't bounce much, but it's a better-run company now.

To get inside even more shoppers' wallets, use the Consumer Discretionary Select Sector SPDR (XLY), an ETF from State Street Global Advisors. It invests mostly in big-store chains but also in brand names, such as Disney and Nike. The fund plunged 26% between July 2007 and January 2008 but has since rebounded 12%.

Heavy industry. Consumer spending accounts for 70% of the economy. But not every investment pro thinks you should put anywhere close to 70% of your portfolio in companies that build homes, make cars, produce breakfast cereal or sell iPods. Rather, says Bruce Bittles, chief investment strategist for Robert Baird, a Milwaukee securities firm, identify companies that will benefit when big businesses spend big again.

One such company is Martin Marietta Materials (MLM), which holds rich reserves of limestone, granite and other materials in quarries across the central and southern states. Because rock is so heavy, it is generally mined for local use. That's why competition from imports is minimal. The stock fell by half between June 2007 and March 2008. Now, at $113, it sells for 18 times estimated 2008 profits of $6.28 a share. Analysts see a healthy 14% jump in earnings next year, and profit forecasts are likely to rise if the economy mends and construction picks up as a result.

For a global alternative, San Francisco money manager Simon Baker recommends construction-equipment giant Caterpillar (CAT). Many investors view Cat as a cyclical company despite its ability to generate record sales and profits even when the economy falters. Thanks to strong overseas sales and the weak dollar, Cat has been largely unaffected by the slump in the U.S. And as of mid June, its shares are up 11% for the year, making Cat the third-best-performing stock in the Dow Jones industrials. Just imagine how the stock might jump if Cat could add the fruits of a U.S. recovery to its prosperous operations in places such as Russia and Latin America. At $80, the stock trades for a reasonable 13 times estimated 2008 earnings of $6.05 a share.

ETFs geared to what might once have been called Smokestack America generally focus on materials or equipment makers. So the best way to play this theme is to split your money between two ETFs. As its name indicates, Vanguard Materials ETF (VAW) puts you right in the middle of commodities makers, such as DuPont, Dow Chemical and Alcoa, not to mention seed producer Monsanto. Put the other half of your industrial money in Vanguard Industrials ETF (VIS), whose biggest holdings include Boeing, Caterpillar and Deere. The annual expense ratio for both funds is a low 0.22%.

Technology. Whether the next economic recovery is tepid or torrid, Paul Latta, of the Seattle brokerage McAdams Wright Ragen, believes technology companies will be leaders. That's because corporate America will continue to cut costs, and the "way to do that is to put cash into better technology," says Latta.

Speaking of leaders, Latta likes Applied Materials (AMAT), the biggest maker of equipment used to produce semiconductors. Morningstar calls Applied "the closest thing to a one-stop shop for chip manufacturers." The company is also extending its expertise in semiconductor gear to the business of solar equipment, which could be a major source of future growth. At $19, the stock is up 7% for the year and trades at a not-so-cheap 24 times estimated earnings of 79 cents a share for the fiscal year that ends in October. But analysts see an earnings jump, to $1.10 a share, the following year.

Oracle (ORCL) has been on a shopping spree and is now the world's biggest seller of business software. Peter Goldmacher, an analyst for Cowen & Co. and a former Oracle employee, says acquisitions of business-oriented software developers, such as PeopleSoft, Siebel Systems and BEA Systems, broaden Oracle's product line as well as its client base. And that should ensure that Oracle will participate more than others in a broad recovery. Meanwhile, says Goldmacher, the $22 share price doesn't reflect the boost those purchases will give to Oracle's growth rate. The stock, which trades at 16 times the $1.37 per share that analysts expect Oracle to earn in the four quarters that end next November, may already be anticipating better times. It's up nearly 25% from its March low.

For a diverse collection of domestic tech stocks, buy iShares Dow Jones U.S. Technology Sector ETF (IYW). It gives you all the top-tier names -- the biggest holdings are Microsoft, IBM, Apple, Cisco Systems and Google -- and is well divided between hardware and software, so you don't have to guess which part of the tech universe is in or out of favor.

NEXT: Remember the Little Guys