After Brutal Q1, Some Sectors Start to Emerge

By Murray Coleman

In the first quarter, investors found little place to hide. None of the major sectors were positive to open 2008, including last year's big performers ranging from energy and telecom to utilities.

But openings started showing as April approached. By the start of the second quarter, strategists and analysts say that key parts of the U.S. market started showing openings, boding a better investing climate for the rest of 2008.

Even in the first quarter, despite a broad sell-off some parts of the market did noticeably better than others. Consumer staples held up the best in the S&P 500, falling 2.78% as shaky economic fortunes didn't stop purchases of food and prescription drugs, among others.

Materials was the second-best performer with average losses of 3.55% in the quarter. That was followed by industrials' 4.47% drop and consumer discretionary 6.25% fall. Energy came in at the middle of the pack with all of the remaining five sectors posting double-digit setbacks.

But it was a tale of two vastly different cycles. After hitting a 52-week low under $33 a share in late January, Industrial Select Sector SPDR (AMEX: XLI) rebounded past $38 before settling some to end the quarter.

Energy stocks stage an even more dramatic tug-and-pull quarter. Take iShares Dow Jones U.S. Oil & Gas (NYSE:IEO). It fell to a low in the mid-$50 per share range in late January. But for most of the following 14 weeks, it moved up strongly to finish at around $75 per share.

"With a market low on the S&P 500 taking place on March 10, it pretty much dragged down most of the groups early in the year," said Sam Stovall, S&P's chief investment strategist for equity research. "The economic conditions still didn't improve much later and the markets remained highly volatile throughout the quarter."

In the past 12 months through March 31, the S&P 500 posted 16 one-day drops of 2% or more - four times its long-term average.

By early March, the S&P 500 had fallen 18.64% from its early October 2007 peak. Since that low-point on March 10, 2008, the benchmark rose 3.3% through quarter's end. "The fundamentals of the market remained about the same in the second-half of the quarter," Stovall said. "But sentiment became more opportunistic as some investors started believing we'd gotten close to a bottom."

A mirror of such change in investment mood could be seen in the Claymore/Zacks Sector Rotation ETF (AMEX: XRO). Using a top-down approach through quantitative modeling of 16 different sectors in the U.S., the fund took a distinctly defensive stance most of the quarter.

XRO moved completely out of financials, oil and energy. It increased its holdings in medical slightly and increased its overweight in computers and technology to about a quarter of the portfolio.

Other smaller shifts included taking positions in consumer discretionary names. "The index wasn't in that area of the market at all before the first quarter," he said. "But it shifted into some of the sector's larger names such as Wal-Mart and CVS," said Christopher Huemmer, vice president of index strategies at Zacks Investment Research, which created the ETF's underlying benchmark.

The theme for the second half of 2007 and first quarter of 2008 was essentially that of a "global margin call," noted Stephen Wood, a senior portfolio strategist at Russell Investments.

He says that as the pool of easy credit dried up as the mortgage meltdown continued in the first quarter, access to all sorts of investment capital became even more restricted.

"The process of banks and hedge funds trying to cover bad debt forced people to sell securities that had value," Wood added.

The result was that almost every major stock index sank in the first quarter. "It was indiscriminate - we really saw an across-the-board fall by stocks," Wood said. "So it's really difficult to draw any long-term, stable investment themes over what we've seen over the last several months."

For a lot of people, he says this is a good time to buy low. A part of Russell Investments' business acts as a sort of manager of index and fund managers. The firm's pension consulting side hires different firms with various expertise in all different areas of the market to execute the firm's portfolio allocations for large pension funds and institutions.

Based on such outside input, Wood says expectations are that the lion's share of stock market growth this year won't come from the U.S. or Europe. "Even though it represents less than a third of the global GDP, we're expecting most of the growth to come from emerging markets. So a trend toward more U.S. investors turning to a globally diversified portfolio is unlikely to go away anytime soon," he said.

Wood added: "In fact, being overweight to their home country is going to be one of the biggest mistakes investors will make going forward."

At Zacks, Huemmer says his computer-generated model shows that a combination of relative valuations, earnings growth and macro trends started finding some good buying opportunities in the U.S. as the first quarter ended.

"It basically moved completely out of medical, including pharmas as well as equipments and services, into basic materials," he said. "The index also shifted out of consumer discretionary and lowered our computer and technology exposure to about 18%. That put our tech exposure at just slightly higher than the S&P 500."

Several weeks ago, the portfolio also got back into financials. That sector is now about in-line with the broader market at about 16.4% of its weightings.

"What we saw is that finance became a much more attractive play by the end of Q1 as prices came down substantially on many of those holdings," Huemmer said. "But as opposed to when in 2007 we were overweighting finance, now we're about in-line with the broader market in finance."

In computer and technologies, earnings growth played a bigger role than valuations in that sector's fall in the index's latest rankings, he added. "It didn't move completely out of the sector, but earnings have come down enough to move the index's weightings in computers and technology to a slight overweighting from a rather large one," Huemmer said.

The fund's benchmark has also taken a significant overweight in materials with about a 20% position after prices rebounded.

"There are really several attractive areas of the market opening for at least the next 90 days," Huemmer said. "The index is slightly less defensive at this point."