Ding, Ding, Ding! It’s Time to Shift!

Investors have been shunning high quality and defensive companies (and sectors) in favor of more speculative investments since the stock market lows in March, 2009. This approach has paid off in spades as the Fed (through monetary policy) and Congress (through tax cuts) continually bailed out poor investment decisions whenever stocks swooned. However, an interesting sea change has developed within the stock market since the end of the first quarter. It appears that money is now (finally) rotating into the more defensive and less cyclical industry sectors. Whether the rotation is attributable to the dramatic slowdown in 1Q GDP growth or to fears about the end of QE2, we believe it is long overdue.

As the graph below shows, the best performing industry sectors over the five quarters ending March 31, 2011 were also the most cyclical sectors: Energy, Industrials, Consumer Discretionary, and Materials. Since the beginning of the second quarter, though, the highly cyclical sectors have been among the worst performing while the more defensive sectors – Health Care, Consumer Staples, and Utilities – have been leading the gains.

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Standards and Poors

We cannot say for sure whether this rotation will last. What is more clear to us, however, is that the days of investors throwing caution to the wind in the quest for outsize gains may be drawing to a close. We continue to believe that the Fed is most responsible for the massive run-up in stock prices over the past several quarters and that continued economic headwinds (most importantly, an abysmal housing market) are underappreciated by many investors. As the Fed attempts to extricate itself from all forms of market sustenance, and our continuing economic problems become better appreciated, we believe investors will continue to rotate into stocks that offer solid growth prospects and better downside protection.

There is good news to report here. Investors like us, who have stuck to our knitting as we withstood the painful cycle of overactive speculation, may finally be in a position to gain from the most favorable relative valuations in many years for our types of companies. High Quality and defensive companies still trade at a sharp discount. There are a slew of companies that trade at very reasonable valuations and offer strong balance sheets, generous dividend yields, strong cash flow, and above average long-term earnings growth and visibility. We expect the gap in valuation between “quality” and “speculation” will continue to narrow in the months and years ahead.

Hang in there,

Michael