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This week, the headlines have changed from "concern over being able to get a debt deal done" to "concern about austerity slowing down the economy." This new round of worries about sovereign deleverging ties in perfectly with today's discussion about some sectors to be invested in and sectors to avoid.

The Macro Thesis

The gist of our trade is that the economy ahead - the next 7-10 years or so - looks totally different than it did during the long boom. You need an investment philosophy that fits that world. And if you think what worked best during the long boom is going to keep on working, you've got a lot of disappointment and heartburn in your future. It's time to rethink portfolio construction.

A world of lower-than-normal economic growth, slow job creation, and perhaps most importantly, credit contraction and continued deleveraging, demands a different strategy. The crux of our thesis is that investors should get long the stuff that people need in countries and companies with clean balance sheets, and get short the stuff that people don't in places that are still highly leveraged or hold questionable assets.

You're going to need two things in the decade to come that you really didn't need during the long boom: Caution and skill. Gone are the days of mindlessly buying an index fund on margin and watching the profits roll in.

What to Buy

The first sector that investors need to take a look at and get overweighted exposure to is energy. I know that sounds obvious, but just because it's obvious doesn't mean it's not true. My guess is that you're as confident as I am that energy, as a sector, is going to outperform things like the financials or consumer discretionary over the coming decade.

If broad exposure to the sector is what you're looking for, go ahead and knock yourself out with the Dow Jones U.S. Energy Sector Fund (NYSEARCA:IYE) or the Energy Select Sector SPDR (NYSEARCA:XLE).

Here are the top 10 holdings of the XLE as of last week:

Exxon (NYSE:XOM) and Chevron (NYSE:CVX) are great companies, as are the rest on that list. If you're going to own the XLE, then don't bother owning those individual names. Round the exposure out with some of these other companies. They fall into two categories.

I'll call this first group "value." These eight companies all trade at a PE of less than 15x on both this year's earnings and next year's. But they all have a PEG of above 1, so these probably won't sit idle. They're all trading between 1x and 2x book value, which means nothing if you're a bank holding dodgy MBSes. But for an energy company it generally means that your current price isn't expensive relative to your assets. All these companies are priced below the industry average relative to cash flow and are expected to grow both cash flow and revenues over the coming year. And to top it all off, every one of these has positive dividend growth over the last five years.

Basically, these are companies that trade at inexpensive levels and generate a lot of cash.

Apache (NYSE:APA)
Chesapeake Energy (NYSE:CHK)
Chevron (CVX)
Hess (NYSE:HES)
Murphy Oil (NYSE:MUR)
Nexen (NXY)
Royal Dutch Shell (NYSE:RDS.A)
Statoil (NYSE:STO)

Chesapeake Energy is particularly interesting. Like a lot of energy companies, it wiped out pretty hard after the crude bubble in 2008, but since then it has crawled back rather admirably, doubling from the mid-teens to around 35.

Click to enlarge

The company should be growing revenues and earnings as far as the eye can see and I particularly like its focus on natural gas. Sometimes we forget about natural gas, but it is an incredibly important resource for our country. Even as crude oil has pulled back in the last few months, Chesapeake has done very well.

Statoil is interesting too. It yields 4.6%. It is a Norwegian company, so you get a little different exposure than you do with some other energy companies.

It doesn't adhere to the above criteria, but Transocean is probably worth looking at again. In a world where natural resources are progressively more difficult to locate and extract, a company like Transocean is very relevant. It missed earnings estimates for a couple of quarters in a row, but it is still reasonably priced relative to sales and is trading at a slight discount to book value. It pays a 5% dividend, too, and has a global footprint which means it can avoid a lot of the baggage in the U.S.

I realize that the energy trade is kind of like preaching to the choir. Pretty much every rational individual I've ever come across believes that this is a sector that needs to be overweighted in investor portfolios. Whether or not asset managers actually do that is another story. But the consensus on Wall Street seems to like the energy sector, even if it's a little boring to get excited about. But boring works just fine for a Trade of the Decade.

The integrated majors are going to be particularly boring, but who cares? The risks are small, and while the returns may be modest, they relate quite nicely to the risks. That's the thing that matters when you're dealing with securities with dividend yields in the low/mid single-digits. I mean, seriously, who among us thinks that U.S. Treasuries at 2.7% represent better return relative to the risk than a company like Exxon Mobil with a 2.4% yield?

So while this part of our big equity trade seems a little obvious, here's one with more divided opinions:
Banks: Short These Things!
Or at the very least, avoid them.
Bank of America (NYSE:BAC) is trading at an astonishing 0.5x book value. Think about that for a minute. The market is assigning the company a valuation that is one-half of the net value reported on its financial statements. If that's not an indictment of our current accounting policies then I'm not sure what is. These financial companies are allowed to mark these exotic assets at prices that they think they are worth. Clearly, the market disagrees with those prices.
So who's right? The banks? The market? I have no idea. Do you? How much are you willing to wager on it?
There's no question that Bank of America could double again to $20. Sure. But it's probably just as likely that it's worth $5. This is guessing, not investing. I'm not convinced there is an individual in the entire world who can break down any big bank's balance sheet and feel confident about the findings. I dunno, but maybe Dick Bove can. He likes them. But he liked them when they were twice as expensive and even four times as expensive.
The stinky assets are all still out there. The hangover from the real estate bubble persists. It's tough sledding for all sorts of businesses right now, but it's especially tough sledding for the banks. They'll be mopping up that ugly mess for a while.
Now, don't get me wrong, there are some banks out there that are just fine. Banks that avoided toxic RMBS'es and didn't dabble in those freaky-deaky CDOs. That's great. If you feel like you can identify those banks and feel confident with the numbers that those firms are reporting you, then feel free to deviate.
But I'm categorically avoiding them, or at least the big ones. Go ahead and get short the XLF if you want to make a broad bet like that. Here's what's in it as of last week:
iShares offers a similar product, the IYF. And it also offers some more specific financial ETFs like the IAT for regional banks or the IAK for insurance companies (which ought to do much better in the coming decade). When it comes to the financials, it's the banks that are the target of my concern.
Have you seen a chart of Japanese banks? Here's one that I used in the book and started talking about way back in 2009.
Zombie banks can move way up and way down, but the point is that they should be dead. If these U.S. banks weren't too big to die they surely would have by now. I don't want to invest in a business being kept alive via life support. Who among us doesn't think that a company like Citigroup (NYSE:C) or Wells Fargo (NYSE:WFC) is in serious trouble behind the scenes and who among us doesn't think that they'll get another bailout if the trouble is too big to obfuscate via wonky GAAP rules? Steer clear of those guys. I know it's controversial, but even JP Morgan (NYSE:JPM) and its Superhero CEO Jamie Dimon have concerning risk/reward characteristics. I'm avoiding it.
A Ridiculously Easy Strategy
If you're a passive investor trying to outperform the market by a little bit over the long-run, allow me to give you a no-brainer strategy for doing so: mirror the S&P and then take that current 15% weighting of financials and give it all to the energy sector.
BAM! Now you're a professional fund manager. Go start that hedge fund you always dreamed of and thank me later. You won't beat the market every year, but 10 years from now CNBC will give you a call and ask you to come on the air and explain how you beat the market over the last decade. You might think I'm joking but I'm not. How long has it been since you ran a comparison of the XLE and the XLF?
Check it out:
Crazy, huh? Financials even lagged during that final frisson, when Wall Street and its perverse incentives pushed the credit world into a state of theretofore unknown ecstasy.
Given the current fundamentals of each sector - one with solid balance sheets and capacity for growth and the other with messy balance sheets and stuck in an environment of deleveraging - I kinda think that pattern will continue.
Don't you?
Disclosure: I am long XOM.
Additional disclosure: Our firm is also currently long XOM. Additional disclosure available at TheDraconian.com/Legal-Notice.
Source: Trade of the Decade: Energy vs. Financials