Rave On, Mister Market

The bull is back and on a tear. Most market indices hit a low on March 11, 2003. Since then, they've been on a three-year run, hitting a peak on May 5, 2006. Despite taking a bit of a mid-year break, the indices began scoring further highs as the year drew to a close. The leaders, of course, were cyclical companies. And they did climb the proverbial Wall of Worry (fears over oil prices, inflation, housing prices and war cooled in 2006 as the Fed quit tightening and corporate earnings continued to impress). The big question now: Which industries and sectors will lead the market over the next year?

Recently, we've noticed a lot of different industries leading the market, which makes picking new ones a challenge. We continue to see value in stocks and believe that the current rally has legs, perhaps for another 12 months. Except it just won't look like the one we've seen in past three years. From the market low in March 2003 to the midyear slump that began in May 2006, cyclical, economically sensitive sectors (energy, materials and industrials; see chart) led the S&P 500. These sectors include companies whose revenues are very dependent on the ups and downs of the economy. The opposite is true of the lagging sectors during that time; health care, consumer staples and telecommunication services are generally considered to be defensive, recession-proof sectors.

On an industry level, a few of the top-performing industries during that period included steel, metals & mining, construction materials, oil & gas exploration and homebuilders. These industries tend to be comprised of small- and mid-sized companies. Among the worst-performing industries were brewers, pharmaceuticals, systems software, soft drinks and packaged foods, which, unlike the previous leaders, tend to be comprised of large, mature companies.

Our value and relative-strength measurements pulled our industry weighting toward cyclical, industrial, even commodity-based industries. We believe those industries were on sale because investors were incorrectly fearful of a slow or sluggish economy, and worried that higher oil prices, war and terrorism would hurt the economy. But when investors realized that the economy was growing and cyclical firms were prosperous, stock prices occasionally surged to reflect fair value. From our perspective, price was trying to catch up with fair value, which, over a three-year period, made for impressive returns in the leading industries.

The Early Summer 2006 Sell-Off

During the market decline from early May through mid-June 2006, the previous leaders dropped the most, which is similar to market corrections seen in 2004 and 2005. When comparing this sell-off to the preceding leadership of the bull market, the dominant leaders of the longer time frame sharply reversed during the relatively brief May to mid-June period.

This sharp and sudden theme reversal, while undesirable, was not unlike a number of reversals investors had endured throughout the previous three years of the bull market. Since our valuation and relative-strength indicators did not signal any clear theme change resulting from this short-term reversal, we maintained our exposure to small- and mid-cap issues in highly cyclical industries, viewing the sharp turnaround as a temporary phenomenon. But, the combination of a sharp decline in cyclical industries and an abrupt, clear-cut sell-off in small- and mid-cap issues eventually proved to be the precursors to a broad and major theme change.

A New Theme Begins to Emerge

After a mid-summer rebound featuring the same cyclical leadership, a new theme began to emerge from July 4 to July 21, 2006; investors returned to selling the highly cyclical industries, seeking safer haven in neglected industries in more defensive sectors. The market then experienced a three-month climb with entirely new leadership. The industries that led the previous three-plus years were sluggish. New leadership in defensive, recession-proof industries began to prevail.

During the next couple of months, our value and relative-strength indicators gradually pulled us away from the former small- and mid-cap cyclical leadership and toward the emerging leadership (marked by mature, stable companies in defensive, steady growth industries, such as pharmaceuticals, diversified banks, systems software, computer hardware, household products, communications equipment and broadcasting/cable TV).

Leadership in Technology and Consumer Discretionary

Since the market low on July 21, 2006, the information-technology and consumer-discretionary sectors have taken the lead — the best and second-best performing sectors from July 21, 2006 to Dec. 13, 2006. Our model shows that both sectors remain undervalued despite their recent strong performance, indicating the key characteristics we seek in identifying a potential market theme: undervaluation coupled with a marketplace that is beginning to understand that fact.

From May to November 2006, we saw an increasingly diverse number of industries lead the market. What began as a theme dominated by more recession-proof industries has steadily broadened. While consumer staples-related industries led in the early stages of the continuation of this bull market, leadership has emerged from various industries that do not necessarily fit into a single economic-cycle category:

• Homebuilding

  The sold-off homebuilding industry within the consumer discretionary sector, which tends to be an early-cycle industry, has recently shown strength.

• Footwear

  Manufacturers are showing some leadership, which, while having some sensitivity to the economic cycle, are much less economically sensitive than homebuilders.

• Computer Hardware

  While this industry certainly benefits from a growing economy, it is not nearly as economically sensitive as industries such as steel and oil & gas drilling, which dominated the market from March 2003 to May of 2006.

We are positioning our portfolios for the changing theme that we believe is taking place. Using our value-driven process as a guide, we are reducing or eliminating lagging industries and increasing positions in the new leading industries. We do not know how long this new theme will last, but given the price discounts to our estimates of fair value, we believe it has the potential to last at least one year.

Craig T. Callahan is president of ICON Advisers, Inc. www.iconadvisers.com