2010 Begins with Powerful Sector Rotation

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 |  Includes: AMG, BIIB, BTK, CELG, CEPH, COP, CVX, DOW, DRG, FCX, GE, GILD, IYR, KO, MO, MON, MRK, PFE, PG, SNY, T, UNH, UPS, VZ, WMT, XOM, XRT
by: Alan Brochstein, CFA

When prognosticators look at the past in order to predict the future, they usually pick between two schools of thought: Extrapolation or Mean-Reversion. In layman's terms, extrapolation is essentially "the trend is your friend", while mean-reversion is "the tide rises, the tide falls". Last year, a year of extremes in terms of both the magnitude of the rally but even more the diversity of the move among the economic sectors, saw Technology stocks rise almost 60% while Utilities and Telecommunication Services stocks rose less than 10%.

Two weeks into a new year, both schools of thought are wrong so far. There has been mean reversion to some degree, as the best performing sectors are lagging, but so are the worst performing ones! The middle of the pack has emerged as an early leader, as you can see in the chart (click to enlarge):

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The middle of the pack (Industrials, Health Care, Financials, Energy and Consumer Staples) make up 61% of the value of the S&P 500, while the laggards last year (Utilities and Telecommunication Services) comprise only 6.5%. I don't want to say that they don't matter, but the market doesn't really depend upon them. The winners from 2010 (Technology, Materials and Consumer Discretionary) represent the balance, about 32.5%, with Technology, the largest sector, representing 19.5%.

So far, it looks like some profit-taking in the strongest sectors, but the profits are being plowed back into the market. Investors are clearly avoiding the low beta sectors at this point. Let's take a look now under the hood.

Technology was last year's star by far, benefiting from too steep a sell off in November and surprising earnings resilience throughout the year. It's not surprising at all to see some selling after a big run, and I believe that we have just experienced some deferred sales from 2009 as investors wanted to postpone taxes or to "window-dress" their portfolios. I think of Technology in several buckets, including software, hardware and semiconductors. So far, the semiconductors are creating the drag, with several names down between 5 and 10%. The widely followed PHLX Semiconductor index (SOX), which rose almost 70% last year, is down over 4% in 2010. On average, the other two areas are up slightly.

Materials, a pretty small part of the market at under 4%, were boosted last year by Freeport-McMoran (NYSE:FCX) and Dow Chemical (NYSE:DOW), while Monsanto (NYSE:MON) tempered the sector's return somewhat. Those trends continue so far into the year.

Consumer Discretionary, which earned third place last year, was just too cheap a year ago. While the Retail component stood out, with the SPDR S&P Retail (NYSEARCA:XRT) up almost 75%, the whole sector was very strong. So far this year, Media and Retail appear to be holding it back somewhat, though the returns are positive. With that said, though, I count 9 of the 79 names as being up double-digit so far and only one down more than 10%. The sector isn't exactly for sale! I have found several investable names, most of them smaller, with a value/defensive posture. You can check out my Top 20 Model Portfolio to see the five names that represent 21% of the portfolio.

Industrials actually had a decent year last year, but United Parcel Service (NYSE:UPS) and especially General Electic (NYSE:GE) masked that performance. The bulk of the sector is comprised of Capital Goods (75%), with the balance in Transportation (20%) and Services (5%). Investors have piled into the Capital Goods companies, with 5 of the 38 names up more than 10% and the median return up 4.75%. This has become one of my favorite sectors, even though I am not expecting the economy to be strong. Like the Consumer Discretionary names in my Top 20 Model Portfolio, the 7 names representing 35% are skewed towards value.

Healthcare's performance last year was very mixed, with biotech and pharmaceutical stocks holding back returns. The Amex Pharmaceutical Index (DRG) rose just 13.33%. The large biotech companies were generally weak, while the smaller ones did well. The biotech companies in the S&P 500 include (in descending market cap): Amgen (NASDAQ:AMGN), Gilead (NASDAQ:GILD), Celgene (NASDAQ:CELG), Biogen Idec (NASDAQ:BIIB), Genzyme (GENZ) and Cephalon (NASDAQ:CEPH). The best of the bunch was only up 12.3%, yet the Amex Biotech Index (BTK) rose a stunning 46%. Of course the overall sector was plagued by fears of Obamacare as well as some surprising softness in sales caused by the economic slowdown. So far this year, investors are snapping up some of the larger names, with 3 of the Top 10 names (Pfizer (NYSE:PFE), Merck (NYSE:MRK) and United Health (NYSE:UNH) all up over 7%. The interest seems greatest in device manufacturers and insurance companies. The Top 20 Model Portfoliostarted the year most heavily weighted towards Healthcare (and especially devices, as we hold some S&P 500 names as well as smaller ones), and it is now at 33% (six names) after the sale of a Healthcare name and the addition of an Industrial.

Financials, the very worst sector in 2008, recovered only modestly in 2009, ending up below the return of the S&P 500. REITs had a decent year, with the iShares Dow Jones US Real Estate ETF (NYSEARCA:IYR) returning 23.3%, but banks held the sector back. As 2010 kicks off, we have seen a big reversal, with IYR down a bit year-to-date, but banks, especially regionals, soaring.

Energy was a tale of two cities last last year. It was the worst of times for refiners as well as integrated companies with significant refinery exposure, while the rest of the sector did quite well. Given that almost half of the market cap of the sector is in a few names, like Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX) and Conoco Phillips (NYSE:COP), the 2009 performance for the sector was quite misleading. The median return for the sector was a stunning 44.7%. So far this year, 7 of the 39 names are up more than 10%.

Consumer Staples, which not surprisingly lagged the rallying market last year after outperforming in 2008, are dominated by a handful of names: Wal-Mart (NYSE:WMT), Procter & Gamble (NYSE:PG), Coca-Cola (NYSE:KO) and Phillip Morris (NYSE:MO), all of which are over $100 billion in market cap and contribute in total about 1/2 the market cap of the 42-member group. Investors cared little last year, and they don't seem to care yet this year.

Utilities lagged last year as well, not surprisingly, though they finished very strong. The 4th quarter enthusiasm hasn't carried into 2010, as regulatory concerns are weighing (especially in Florida). I contributed an article on the sector to my friends at TradeKing in December, and people more knowledgeable than I am about the sector might benefit from checking it out. I would add that the resurgence in Industrials, if it is to be believed (a big if) suggests that Utilities may see a recovery in industrial power demand.

Telecommunication Services is just 9 stocks, only 2 of which matter: ATT (NYSE:T) and Verizon (NYSE:VZ). The stocks puzzled folks last year for failing to perform, but the harsh reality of a very competitive environment became clearer this past week, with the two big guys now nursing close to 8% losses after earning a bit less than their dividend in 2009.

So, that's a peek at the start of what should be in my view a year of continued rotations from and within sectors. I don't expect the market to be in a substantially different neighborhood a year from now, so I plan to be a mean-reverter. For now, I am heavy in the sectors I described above and definitely tilted towards small-cap and towards value.

Author's Disclosure: No position in any stock mentioned.