Cyclicals vs Defensives

Renewed strength in the U.S. equity market sponsored by another round of global monetary easing has revived the debate about whether it is finally time to transition out of our <i>alpha</i>-generating defensive portfolio strategy. This <i>Special Report</i> examines the critical factors shaping this investment decision.

The Fed's decision to scale back intended interest rate hikes reflects economic reality.

While we are neutral the broad industrials sector (please see yesterday's Insight) and sub-surface exposure should remain selective, we continue to recommend an above benchmark weighting in the BCA defense index. Following years of global government austerity, rising global fiscal thrust should boost demand for defense capital goods. Tack on a rise in geopolitical risk in a number of volatile regions in the world, and the outlook for defense spending significantly brightens. In more detail, China/Japan nervousness (with Australia recently joining the chorus of rising defense spending in the pacific) and escalating middle east/Russia tensions are a harbinger of rising defense spending budgets globally. The prime beneficiaries of this cyclical turn in demand are U.S. defense manufacturers/contractors. Already, U.S. defense new orders are surging, signaling that relative performance momentum has more upside (middle panel). Importantly, the U.S. defense capital goods shipments-to-inventories ratio is also expanding at a healthy clip (bottom panel). The implication is that busy defense factory activity should underpin revenue and profit growth. Bottom Line: Stay overweight the BCA defense index. The ticker symbols for the stocks in this index are: LMT, GD, RTN, NOC, LLL. Bulletproof Defense Bulletproof Defense

Economic disappointment represents a serious obstacle for stocks. Stay with non-cyclical plays, including telecom services and health care. Upgrade the managed care group, and stay clear of banks, regardless of cheap valuations.

With the broad market struggling to find a floor in the midst of a disappointing earnings season, it still pays to play defense. This week's ISM releases reinforce that a defensive over cyclical portfolio bias is still warranted. The bottom panel of the chart shows the relative employment outlook for ISM manufacturing versus ISM services, with the pendulum swinging in favor of services industries. This relative employment ratio heralds more pain for cyclical vs. defensive equities, as most defensive sectors are services-oriented while deep cyclicals are manufacturing-intensive. Meanwhile, the bond market continues to flag elevated financial stress. Cyclical junk bond yields have been shooting higher, especially compared with defensive junk yields, reflecting relative deteriorating balance sheets. The implication is that relative share prices have more room to fall (top panel). Bottom Line: we continue to recommend a defensive versus deep cyclical portfolio tilt. Defense Is Still The Best Offense Defense Is Still The Best Offense