COMMENT
Picking The New Hot Sector

By Ed Bowsher (TMFArkle) (TMFArkle)
October 6, 2005

Oil and Gas has been a hot market sector for the last year, even after this week's share price falls. If you randomly picked three oil stocks last October, and had just sold them, you'd have been very unlucky if you hadn't made a nice profit.

So what sectors could perform well over the next twelve months?

One way to assess this is to look at the economic cycle. If you know where we are in the cycle, there's a decent chance you can predict which market sectors will outperform in the near-term.

It's a fact of life that booms are followed by busts. These cycles often last around for five years, although the time periods appear to be extending.

For our purposes we don't need to know why cycles happen. We just need to decide where we are now. Sam Stovall, a strategist at Standard & Poor's, has developed a model where the economic cycle is divided into five segments.

The first segment is early expansion. At this point interest rates tend to be low, inflation is falling, and industrial production is beginning to rise. That's because central banks have lowered interest rates to boost the economy. The bankers aren't worried about inflation because there isn't sufficient demand in the economy to trigger big price rises.

As we move into middle expansion, industrial production rises much more quickly and inflation is low. Interest rates begin to rise gently as central bankers worry that prices might pick up a few months down the line.

In late expansion, interest rates and inflation rise more quickly while industrial production flattens out.

Then the economy either slows down or we experience a full-blown recession. Likewise, industrial production either slows down or falls. Inflation and interest rates stay high. This is early contraction. As the bad times bite we move into late contraction - industrial production stays in the doldrums, interest rates fall, but inflation stays high.

Where are we now?

The Office for National Statistics said today that total UK industrial production fell by 0.9% in August. These figures were worse than expected. Inflation has risen recently while interest rates were reduced in August to 4.5% - the first cut in a year.

Those numbers suggest we may be moving from early to late contraction.

Stovall has argued that investors should look at financial stocks and consumer cyclicals when we're in late contraction. That seems odd at first glance; consumer cyclicals includes areas such as cars, retail and restaurants. Surely families will make fewer trips to Pizza Express during bad times?

The market, however, is always looking forward. Investors like to be ahead of the game and anticipate what will happen next year. If we're in late contraction now, good times should be coming round the corner - or so the theory goes.

There are some snags of course. Firstly, I'm not sure whether we've moved from early to late contraction yet. What's more, I'm not sure how long the current economic cycle will last. Even Gordon Brown keeps changing his mind on that one.

And sometimes sectors outperform thanks to structural changes rather than the economic cycle. Oil bulls, for example, argue that the rising oil price has been partly triggered by increasing demand from a rapidly industrialising China. Yes, Chinese oil demand may slip if the global economy falters, but the long-term trend is definitely up.

If playing the market by sector rotation was easy and risk-free, everyone would be doing it! Still, rotation is worth bearing in mind when you make your stock selections.