Bottom-up

We have talked several times about the top-down aspect to tactical sector investing, where macroeconomic developments and where we are in the overall business cycle help to drive sector returns. For example, as of late we've seen a return to a largely 'risk-on, risk-off' trade as investors have focused on world events such as the European debt crisis. When fear has risen, defensive sectors have tended to do better, while more cyclical sectors have done better when that fear level subsided. And while the top-down analysis is vitally important when looking at tactical investing for sectors, it’s also important to look at the groups from the bottom up.

Bottom-up analysis involves looking at the specific characteristics and fundamentals of an individual sector. What do earnings and cash flow trends look like? Are there new innovations in a group? What do valuations look like relative to historical tendencies and the overall market? All of these questions and many more are factors that we look at when examining a sector in a bottom-up manner.

From a top-down perspective, we continue to hold a slightly cyclical stance by holding outperforms on information technology and industrials, while rating consumer staples and utilities at underperform. We have kept information technology at outperform despite some occasional blips in the sector due to growth scares, inventory concerns, and supply chain issues as we believe these are largely temporary issues that provide potential buying opportunities. We believe that the tech sector is far more stable than it was in the 1990’s. We've been touting this stability as one of the reasons to stick with the group, and in fact, the sector has outperformed during the recent downturn in the market, illustrating some of the growth tech defensiveness we've seen developing. We have kept industrials at outperform because we believe this sector will start to see a renewed acceleration in economic activity in the coming months. This should benefit the industrials sector as businesses look to invest in their equipment and put large cash balances to work.

Consumer staples have remained at underperform because we currently don't believe this performance is sustainable at the moment. We believe the economy will perk up in the coming months and that its defensive characteristics will become less attractive to investors over the coming months. As for the utilities sector, there may be no sector more associated with defensive positioning. Investors typically flock to the group when economic uncertainty increases and away when growth expectations improve. Although we've seen outperformance as a result of rising concerns of a return to recession, we believe those fears are overblown and are maintaining our underperform view as we believe economic activity will pick up in the coming months, although risks are certainly elevated.

We view the accelerated depreciation tax incentive for 2011 as a potential tailwind for both the tech and industrials sectors. Expiring at the end of the year, this change in the tax code allows companies that make capital investments this year expense the total cost of the investment in this year, as opposed to depreciating the asset over a period of years. This allows companies to reduce their tax liability for 2011 instead of having to spread the benefit out over several years. When we’ve seen this sort of incentive in the past, we’ve seen a surge in capital expenditures toward the end of year of expiration, and we believe that will occur this year as well. This is but one of the bottom-up type factors that we look at, but provides an insight into the process.

As noted, our current stance leans toward the cyclical side as we expect economic activity to improve in the coming months as we get past some of the temporary events that have seemed to bog down growth, and damage the market. We want to note, however, that risks to that view have risen as of late and that we will not be dogmatic in our current stance and recognize that if confidence doesn’t begin to rebound in the near future, the year-end outlook will have to be downgraded and we would be forced to shift our views. As summer winds down, back-to-school season ramps up, and we get further away from the temporary factors mentioned above, we will watch the forward-looking data coming in for clues as to future developments. For now, the yield curve remains relatively steep, which has typically been a good indicator of decent growth going forward, jobless claims have edged lower, and both ISM indexes, while deteriorating, remain in territory depicting expansion.

We also continue to hold a marketperform rating for Consumer Discretionary, Energy, Financials, Health care, Materials and Telecoms. Our recommendations can and do change quickly at times as we continually monitor economic progress and specific factors influencing individual sectors.

Kully Samra is UK branch director at Charles Schwab.

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