Stock market investing strategy: Why cyclical firms could rally - Business Insider

Jim Paulsen, chief investment strategist at Leuthold Group, is telling investors to look harder at groups of stocks tied to the economy.So-called cyclical stocks generally haven't done as well as more economically linked stocks, partly because investors fear growth is going to slow. Paulsen argues that those fears actually contribute to the stocks' appeal.While Paulsen is taking an optimistic view of banks, industrials, and materials companies, he thinks the consumer discretionary sector doesn't look as attractive.Click here for more BI Prime stories.Every day, experts tells investors to buy stocks that look great but have escaped the public's notice. Less common is when those experts say to buy some stocks because, on the surface, they look bad.That's what Jim Paulsen — the chief investment strategist at Leuthold Group — is doing when it comes to cyclicals, the groups of stocks that are most sensitive to the US economy. The term encompasses industrials, basic materials makers, financials, and consumer discretionary companies.Paulsen notes that the performance of the stocks is frequently erratic, and they often begin to do best at times when, according to traditional measurements, they look the worst.“What is the best time to buy a stock that's really sensitive to the economy？ It would be when you're in the pit of a recession and you're just about ready to exit,” he told Business Insider in an exclusive interview.He added: “You would be buying it when its earnings look terrible, when its sales look terrible, when its balance sheet would probably look challenged, when its valuation is sky high because it doesn't have any earnings.”On the other hand, he says, by the time the valuations and earnings look good, a rally in cyclicals is probably about to end. Paulsen says it's these four factors, rather than those metrics, that make him think the stocks could be ready to outperform.(1) Relative total returnBy this measurement, if not by more famous ones, Paulsen says the cyclical sectors are appealing because their returns have lagged the market, and got dramatically worse from early 2018 to early this year.“They have been washed out on a relative basis,” he says. “The fact that they have underperformed for as long as they have and by as much they have, that's one factor that makes them look attractive right now.”He backs that up with this chart, published in a note to clients, showing that similar slumps in total return in the past have been followed by strong recoveries.

Jim Paulsen of Leuthold Group says the returns of cyclical stocks could improve if they follow their historical pattern.

Leuthold Group

(2) The bleeding stoppedAfter that big drop in relative returns, Paulsen says returns for cyclicals have stabilized recently even though the global economy is awash in frightening news.“Even though there still a global slowdown, even though it's still a manufacturing recession, even though there's still concerns about a recession, even though there's a trade war, all those factors are out there, and yet these stocks have stopped underperforming,” he says.And that's a good sign because a similar pattern of stability, rather than a V-shaped recovery, played out after the Global Financial Crisis, the slowdown in 2011, and the oil price plunge in 2015-16.(3) Fear factorPaulsen continues that pessimism around the health of the economy is affecting the stocks to the point that a recession is more or less priced in. That means there's a lot of room for things to turn out better than investors expect.“I like the fact that there's a lot of fear,” Paulsen says, because that can be the source of pent-up demand. “It tells me that these stocks are probably under-owned in most portfolios.”That means that investors could pile back into the sector when they see clearer signs of your improvement, and to Paulsen, someone who buys them earlier than that can benefit from that trend when it arrives.(4) Bank on itIn contrast to the other three factors, this one is well known: Central banks around the world are lowering interest rates and using other stimulus measures to keep the economy growing. That's all helpful to cyclicals.“Policy officials are working really hard to improve the relative performance of your cyclical stocks by dropping the longterm cost of capital almost in half over the last year... by exploding the money supplies, by increasing fiscal juice over the last year, and kind of keeping the dollar flattish as opposed to continuing to go up,” he said.How he's playing itPaulsen says he remains overweight on the technology and communications sectors, but that he would complement it by investing more money in three of the four cyclical sectors, specifically industrials, materials, and financials.He says those stocks could benefit from different trends, as an easing in the trade war and a drop in the US dollar would help industrial and materials, and banks would rise if investors expect more inflation.He's less optimistic, however, about consumer discretionary stocks, which have mostly performed better than the other cyclical groups“The other ones all benefit from a pickup in inflation, and overheat pressures to some degree materials and industrials, financials, will all benefit not only if the economy picks up but if inflation picks up,” Paulsen said. “But inflation really hurts the consumer discretionary sector because it tends to crimp their margins.”Investors who want to implement that strategy could do using exchange traded funds like the SPDR S&P Bank ETF, the iShares US Industrials ETF, and the Vanguard Materials Index Fund ETF.