Henk Potts considers which sectors should provide greatest resilience in turbulent markets

It has undoubtedly been a terrible year for equity markets. No sectors, and very few stocks, have been spared. Since the start of 2008, of the 1,728 stocks in the MSCI World index, only 77 (just 4.5 per cent) have managed a positive return. That said, sector performance has varied widely. The difference between the best-performing sector – consumer staples – and the worst – financials, unsurprisingly – has been around 35 per cent, a fairly typical level since the start of the decade.

So, what lessons has sector strategy for investors – in the short term, over the next three months and in the longer term, up until the end of 2009?

Stay defensive in the short term
Looking at the sector performance table for 2008, it is no surprise that it has paid to be defensive. Consumer staples, healthcare and utilities top the leaderboard. Cyclical sectors like financials, materials and industrials have been the biggest fallers.

Going forward, we do not know how long the market turbulence will last, and when we will switch to a more aggressive stance. But we do know two things: firstly, that bear markets do not last for ever; and secondly, that equity markets tend to lead the economy by a couple of quarters. On that basis, we expect equity markets to set out on the long road to recovery at some point in the next six months.

With this in mind, we have looked at the ‘early warning signs’ that tell us when to start focusing on cheaper, cyclical sectors. We have studied various indicators that can help to predict turning points in the economic cycle. These indicators – including the ISM manufacturing index, corporate bond spreads and the yield curve – are mainly focused on the US economy, as that tends to lead the world cycle. In the short term (in other words, over a three-month horizon) an improvement in these lead indicators would be a sign that it is time to become more aggressive.

However, the signals are not there just yet, and until such time, our short-term sector recommendations stay defensive. That means that, over a three-month investment horizon, we still recommend stocks in the defensive healthcare and telecoms sectors, and would avoid oils and materials.

Our expectations for 2009
In our view, the economic signals are unlikely to turn positive before the end of the second quarter of 2009. Our medium-term recommendations (i.e. over a 12-month horizon) are dominated by valuation factors, as momentum indicators are more useful over shorter time horizons. After the sharp sell-off in markets this year, readers will not be surprised that the cyclical sectors currently seem to offer the most value.

Our valuation models suggest that we should expect cheaper cyclical stocks in
the financials, materials and consumer  cyclical sectors to outperform over the next
12 months. But we see much less value in the defensives, notably utilities and consumer staples.

Of course, models can be wrong, especially at a time like this when there is total uncertainty about corporate profits, from which our valuation models are derived. We still think the outlook for corporate earnings is too optimistic, even though November was the worst month for downgrades in 20 years, and estimates will continue to fall for some months.

Following the cycle
We have ‘stress-tested’ our assumptions by adjusting our models to reflect a collapse in earnings of a similar size to that seen in previous recessions, but even then, our models still prefer cyclical rather than defensive sectors.

Even more encouragingly, our models’ current recommendations also fit quite well with our wider economic views. We expect the current recession to start to fade in the second half of 2009, which means that equity markets and riskier assets in general should start to recover in the first half of the year. Since both our models and our economic analysis support this view, we are reasonably confident about our sector strategy for 2009.

Henk Potts is equity strategist at Barclays Wealth