How To Trade The Virtuous Economic Cycle

by: BubbleBustInvesting

Everyone who has been around Wall Street long enough knows very well what a virtuous cycle is: An improving economy is helping equity markets recover, and improving equity markets are helping the economy improve further. The mid-to late 1990s is a case in point. After recovering from the 1990-91 recession, the economy fueled an equity rally, which in turn help the economy sustain its momentum.

While history doesn't always repeat itself, or at least not in an exact fashion, several recent macroeconomic indicators (e.g., a brightening labor market picture and better manufacturing data) suggest that the U.S. economy may finally be improving. Wall Street has certainly taken notice, as major equity indicators have been regaining old highs. This, in turn, may help the economy sustain its gains through the "wealth effect," the positive impact of asset appreciation on consumer spending. What does it mean for investors? Which sectors are to benefit the most from this virtuous cycle?

Here are some ideas investors may want to consider:

1. Buy Homebuilders. A virtuous cycle is very bullish for homebuilders, as it increases the likelihood of people buying homes. Besides, economic fundamentals for the industry have been improving: New home inventories are declining, homebuilder confidence is improving, home prices are stabilizing, and industry leaders like Toll Brothers (NYSE:TOL) have been reporting better-than-expected earnings results. Conservative investors may want to buy an ETF investing in homebuilder stocks like SPDR Homebuilders (NYSEARCA:XHB) and Ishares Dow Jones Home Builders (BATS:ITB), or buy the shares of diverse homebuilders like D.R.Horton (NYSE:DHI). Aggressive investors may want to accumulate the shares of individual homebuilders that have been taking steps to address the housing crisis early, like Lennar Corporation (NYSE:LEN), Toll Brothers, Standard Pacific (SPF), and Hovnanian Enterprise (NYSE:HOV) - though due diligence is recommended.

2. Buy Cyclical Stocks. A virtuous cycle is good news for cyclical stocks like Ford (F), General Motors (GM), Toyota Motor Company (TM), and Honda Motor Company (HMC), Nike (NKE) and Coach (COH).

3. Avoid High-flying energy Materials and Precious Metals. A virtuous cycle diminishes the prospect of further QE by the Fed. This is certainly bad news for high-fliers in the materials and energy space like Walter Energy (NYSE:WLT), Cliffs Natural Resources (NYSE:CLF), Oil Service Holders (NYSEARCA:OIH), Ishares silver trust (SLV), SPDR Gold Shares (NYSEARCA:GLD) (up 100%) and Freeport-McMoRan Copper and Gold (NYSE:FCX).

4. Avoid non-cyclical stocks. These stocks fare better during a declining rather than expanding economy like big pharma stocks - Pfizer (NYSE:PFE), Bristol-Myers Squibb (NYSE:BMY), Abbott Laboratories (NYSE:ABT), Eli Lilly (NYSE:LLY) and Merck (NYSE:MRK) - that enjoy hefty profit margins, ranging from 19% to 32%; and pay hefty dividends, ranging from 3.80% to 5.5%, compared with 1.88% for S&P 500 stocks (NYSEARCA:SPY).

5. Stay with bellwether stocks like Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG) and Microsoft (MSFT) with dominant market positions that are well-position to benefit from a rebound in consumer spending.

6. Stay away from U.S. Treasuries--and Treasury ETFs like AGG, BND, LAG, and TLT. A stronger economy is bad news for Treasuries, especially at a time when they trade at record low yields.

Disclosure: I am long LEN, HOV, HOV, ITB, DHI, MSFT, AAPL.