After share prices slid lower for seven out of eight weeks beginning in May, the S&P 500 Index enjoyed an overdue rebound rally, posting a 5.6 percent gain last week.¹

The financial media assigned a number of probable causes for last week’s rebound, including better-than-expected data from the manufacturing sector and an uptick in housing starts.

We believe the real catalyst for a sustained move higher from here is likely to be found in a lack of additional bad news combined with attractive valuations for equities — especially in sectors sensitive to the economy.

In a recent issue of the Banyan Market Letter (Issue 22 • June 22, 2011), we made our case for why stocks offer compelling value. We also pointed out that pervasive investor pessimism could be a powerful catalyst in sustaining a renewed rally.

Sentiment Swing

Simply stated, when sentiment swings too far in one direction (bearish) as it did in May and June, you should expect the pendulum to swing back just as sharply in the opposite (bullish) direction.

That’s not to say we’re out of the woods just yet. Concerns remain, including the Eurozone debt crisis. It seems that EU officials are committed to an “extend and pretend” policy, preferring to bail out Greece and the other PIIGS with an endless series of liquidity injections rather than tackling the bigger solvency issues these nations face.

And, of course, the US faces a debt issue of its own, with politically charged negotiations likely to be contentious in the weeks ahead, perhaps leading to further market volatility as summer progresses.

Still, these concerns are nothing new. Consider that the Eurozone debt crisis first made headlines over a year ago with the first Greek aid package. And politicians in Washington have been posturing over budget negotiations for months.

At this point, we believe financial markets may have already discounted most, if not all, of the worst-case scenarios.

Watch Sector Relative Performance

At Banyan Partners, our investment team is closely watching the character and composition of the market rally for clues about where we go from here.

The relative performance among sectors can give investors valuable clues about where we are in the current economic cycle. On that note, we are encouraged by the leadership on display during last week’s rebound rally and we’re watching for more of the same.

The best-performing sectors last week included energy, which surged over 7 percent higher, followed by technology (+6.8 percent) and consumer discretionary (+6.6 percent). All three are cyclical sectors representing stocks that are highly sensitive to changes in the economic cycle.²

The outperformance of these sectors tells us that, in spite of the soft economic data we’ve seen lately, investors may already be looking past this soft patch and placing bets on a strong rebound in economic growth later this year.

Mid-Cycle Sweet Spot

Cyclical sectors like energy and technology are two sectors that could benefit the most from an improvement in the economy.

Other cyclical sectors including industrials, materials and financials likewise outperformed the S&P 500 last week. Meanwhile, defensive sectors such as utilities and consumer staples lagged.³

Historically, leadership among cyclical sectors has been a classic sign of the middle phase of the economic expansion.

We believe that a continuation of this performance trend — favoring cyclical stocks over defensives — tells us the economy is most likely on track to rebound from a temporary soft patch. In fact, the magnitude of this rebound could catch many by surprise.

As Banyan’s Chief Investment Officer Michael Blackmon notes, “It’s a matter of shifting investor perception.” Just as surprisingly weak data on the economy drove stocks lower in May and June — creating a buying opportunity in our view — better-than-expected data could now drive stocks higher in the months ahead.

The good news is that this point in the cycle has been a sweet spot for further stock market gains in the past … with the best performance delivered by technology, energy, industrial and basic material stocks.⁴

Historically, the mid-cycle phase of the stock market’s advance begins roughly three months before the Federal Reserve begins raising interest rates and lasts for about one year.⁵

However, with Fed policy clearly on hold for an “extended period,” it’s likely that we may enjoy an extended mid-cycle phase of this business cycle.

Cyclical Sectors Offer Compelling Value

As an added bonus, it’s the economically sensitive stocks and sectors that appear most attractively valued right now. These sectors got hit hardest during the correction in May and June as investors began to worry about an abrupt economic slowdown.

As a result, the Morgan Stanley Cyclical Index, which includes many leading industrial and commodity stocks, is now trading at a forward price-earnings ratio (P/E) of just 11.6 times expected profits. That’s a significant discount compared to the average P/E of 17.5 for this index since 1993.⁶  

What’s more, earnings growth for companies in the cyclical index should surge 30 percent in 2011, followed by 23 percent profit growth next year, according to analyst estimates!⁷

Bottom line: In our Banyan core equity accounts, we have been overweight the cyclical sectors including technology, industrials and materials for some time. We trimmed some positions to raise cash in early May in anticipation of a short-term pullback in stocks.

Recently, we’ve started putting that cash back to work. This latest 8 percent market correction makes cyclical stocks look particularly attractive and poised to outperform the overall market, in our view.

We’re convinced these sectors offer the most upside potential at this point in the business cycle and we expect economic growth to rebound in the second half of the year.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

The opinions expressed in this newsletter are subject to change without notice and do not represent a complete analysis of every material fact with respect to any industry or sector mentioned in this report. The strategies mentioned may not be suitable for all investors. This information has been prepared solely for information purposes and is not a solicitation or an offer to buy a security, instrument, or to participate in any trading strategy.

¹ Bloomberg market data, as of 7/1/11
² Ibid.
³ Ibid.
⁴ FMRCo. MARE: Sector Investing: Mid-Cycle Leadership Patterns Emerge, 4/1/11
⁵ Ibid.
⁶ Bloomberg market news, 7/5/11
⁷ Ibid.