Hints of the Future In Today’s Topsy-Turvy Stock Market

The recent rally was a chance to see which shares would likely lead the next major market advance.

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Last week, the stock market enjoyed its best five-day run in more than two years, then gave back most of those gains on Monday.

Individual investors would generally be well-advised to ignore these short-term ups and downs and to focus on their long-term strategy. And it’s tempting to leave it at that. However, during brief rallies like last week’s, investors have an opportunity to see which companies have the potential to be leaders in the next major market advance, just as though they were watching horses working out before a big race. And right now, energy and technology look like the favorites.

It may seem puzzling when stocks perk up the way they did last week, only to be smacked down again a few days later. After all, nothing really changed. Why does the market rise and fall so suddenly? Basically, what we saw last week was a relief rally. Minor improvements in the economic outlook produced a brief upswing as investors became a little less anxious. That was cut short as soon as the next bad news was announced.

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To assess the various stock sectors, it’s helpful to look at how they fared over the past three months, as the market was generally falling, and how they performed in the most recent rally. Basically, the sectors divide into four groups:

  • Bank stocks and other financials, which performed badly in both periods. No surprise there.
  • Defensive stocks – consumer staples, utilities and other shares with above-average yields, which held up well when the market was falling but lagged when it rallied.
  • Economically sensitive stocks – energy, industrials and raw materials producers, which suffered when the market declined but bounced back when it rose.
  • And technology, which performed slightly better than the market in both periods.

What does all this mean for your own investing strategy? For starters, stay away from anything connected to banking unless there is a big selloff – triggered by a Greek default, for instance. At that point, you can consider whether the group has finally hit bottom.

Utilities, other high-yield stocks, and defensive groups such as health-care and consumer staples are all worthwhile for the conservative part of your portfolio, especially if you’re retired and you need current income. But they probably won’t continue to be superior performers once the economy picks up again.

Technology looks like it has hit bottom and will only perform better when the economy improves. It seems quite probable that the leading tech businesses – from the Internet to smart phones – will keep expanding. As I discussed in last week’s column, the values among large tech stocks include Applied Materials, Corning, Intel and Microsoft, as well as iPhone service providers AT&T and Verizon.

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The case is even simpler for energy. The oil price is currently depressed by the lousy world economy. Whenever a solid recovery gets going, the price of oil will rise, perhaps by a lot. And there are plenty of safe giant oil stocks, often with very good dividend yields, to choose among: Exxon, Chevron and ConocoPhillips in the U.S.; and Royal Dutch Shell and BP internationally.

A well-balanced portfolio today generally should include defensive investments that offer above-average yields, as well as stocks that would benefit from a stronger economy. But you should pay special attention to those shares that have shined during the most recent rally. Those sectors are likely to include some of the best long-term bargains.