How to Invest in a Zigzag Economy

The US remains mired in the early stages of a recovery, while emerging markets are speeding into later stages. Knowing how to bridge the gap is key to picking stocks now.

Are you in the right sectors of the stock market for this point in the economic recovery? Solid data stretching back to 1945 show that certain industries and sectors outperform during specific stages of any economic recovery.

No argument from me on that. I think investors should do everything they can to put the power of the economic cycle behind their portfolios.

Just a couple questions, though: Where exactly are we in the economic cycle? And in the new global economy, does it still make sense to think about over- or underweighting sectors, just on the basis of where the US stands in the economic cycle?

My answers to those questions are complicated (and take up the rest of this column). The short response is that the US economy is in the early recovery stage of the economic cycle. That means you should be overweighting the sectors that do best in that stage: Basic materials, as well as industrials near the beginning of this stage and energy near the end.

But my best estimate is that the global economy is further along in the recovery cycle, and that this is especially true for emerging economies. I think the global economy has made the transition from early- to late-stage recovery. That means that for foreign stock holdings (and for US companies that rely on sales in the developing world for growth), you should be overweighting those sectors that do best in the late stage of the recovery cycle. Energy typically does well in this stage, and, near the end of the stage, consumer staples and services also tend to prosper.

Confused yet? Let me explain now in more depth and lay out a way for you to position your portfolio for this unique moment in the global economic cycle. I’ll end by suggesting a few stocks that I think fit our rather complicated picture.

A Primer on the Economic Cycle

The best work on this subject comes from Sam Stovall, the chief investment strategist for Standard & Poor's Equity Research. His 1996 book, Sector Investing, is still the best resource on the subject.

Stovall divides the economic cycle into four stages:

• Early recession: You should remember this stage vividly. Consumer sentiment ranges from fear to terror. Industrial production plunges, interest rates peak and then start to fall, and unemployment begins to rise rapidly. Sectors that have done well—relatively, at least—during this stage include services (near the beginning), utilities, and (near the end of the stage), cyclicals and transportation stocks.

• Full recession: Gross domestic product tumbles, interest rates keep falling, and unemployment rises. Sectors that do best during this stage historically have been cyclicals and transportion. Technology performs well at the beginning of the stage; industrials benefit near the end.

• Early recovery: Consumer sentiment improves, industrial production turns up, interest rates hit bottom, and unemployment peaks and starts to move lower. Sectors that do best are usually industrials (near the beginning of this stage), and basic materials and energy (near the end).

• Late recovery: Interest rates rise as the central bank tries to control inflation, consumer sentiment heads down, and industrial production is flat. Sectors that have done well in this stage include energy and, near the end of the stage, consumer staples and services.

In 2009, it seemed we were well along the path to recovery. The economy had bottomed in the second quarter with US GDP contracting by 0.7%. The economy then grew by 1.6% in the third quarter and by a huge 5% in the fourth quarter.

The recovery was off and running. In January 2010, I wrote that we were in the early recovery stage of the economic cycle.

And then the economy double-crossed us. In 2010, GDP growth dropped to 3.7% in the first quarter and to 1.7% in the second quarter.

1.7%? Wasn’t that just about the 1.6% growth investors had seen back in the third quarter of 2009?

No wonder lots of economists and investors started to worry that we were headed to a double-dip recession—and that the next quarter would show a drop back to something like the negative 0.7% growth of the second quarter of 2009. But luckily, the economy decided that it had at least one more zigzag up its sleeve. Economic growth accelerated to 2.6% in the third quarter of 2010 and now economists are expecting 3.5% growth for the fourth quarter of 2010.

Déjà Vu All Over Again

As of this January, in my opinion, the United States is back in or still in (take your pick) the early recovery stage, and a little bit further along the way from early recovery to late recovery. In the past calendar year, I think we’ve traveled the equivalent of what would take maybe three to four months in a typical economic cycle. At this rate, I don’t think we’ll enter the late recovery stage until the end of 2011 or so.

Emerging economies are further along. Since they rebounded more quickly from the global economic crisis, they’ve moved faster through the economic cycle and are now approaching late-stage recovery.

Although I don’t see any signs yet that industrial production is flattening—we’re talking about China, India, and Brazil here—we are seeing interest rate increases designed to slow what I think is already runaway inflation in all of these countries. (For a closer look at global inflation, see my recent column "Prepare for the Inflation Fight Now.")

We are seeing some signs that consumer sentiment is weakening in developing countries. Recent surveys indicate that rising food prices are leading consumers in emerging markets to think about cutting back on discretionary purchases (a trend I recently wrote about in "Profit from Soaring Food Prices"). For now, those worrisome signs are few, mind you, but certainly they need watching. After late-stage recovery comes early recession.

So how do investors come up with a strategy that fits all these complexities?

I think it boils down to developing a two-track investing approach tailored to the stages in which the United States and emerging economies find themselves. You shouldn’t keep those two tracks completely separate, though. When investing in the United States, you need to keep in mind the effects of the “late recovery” emerging economies on those US companies.

How do you do that? I gave a good example of the methodology in this recent update focusing on Johnson Controls (NYSE: JCI). In that post, I went through the sources and geographical distribution of the company’s business to highlight the balance among slowing and accelerating economies, sectors, and industries.

Check Your Timing, Here and in Emerging Economies

I’d stress that you need to include the timing of growth and slowdown in the United States and emerging economies in this analysis. Right now, for example, makers of production equipment for everything from LEDs to automobiles are showing gangbuster growth as producers in both the United States and emerging economies order equipment to increase capacity and improve efficiency.

This has meant boom times for an array of companies, including several that I’ve written about recently or own in my Jubak’s Picks portfolio. Siemens (NYSE: SI), Aixtron (Nasdaq: AIXG), ASML Holding (Nasdaq: ASML), and, among less familiar companies, German industrial robotics maker Kuka (OTC: IWKAF) and Switzerland’s Schindler (OTC: SHLAF), the world’s biggest maker of escalators, have all been mentioned.

But any slowdown in the emerging economies will take some of the boom out of these stocks. And as an investor, you need to watch for the timing of that slowdown. Since emerging economies are further along in the economic cycle than are the economies of the United States and Germany, any slowdown for these companies could come earlier than you’d expect if you paid attention to just the economic cycle here or in Europe.

One area that I’ve been watching recently that looks well positioned to benefit from the relative economic cycles of both the United States and the emerging economies is drilling equipment and services. I’ve seen new orders reported by companies that make drilling platforms, such as Singapore’s Keppel (OTC: KPELY), and very solid quarterly financial reports from service companies, such as Schlumberger (NYSE: SLB).

This sector would seem to be a good one for bridging the early/late recovery cycle gap between the United States and the emerging economies. Look for a pick or two later this week.

Related Reading:
Why 2010 Was So Volatile—and Why 2011 Will Be Just as Wild a Ride

At the time of publication, Jim Jubak did not own shares of any of the companies mentioned in this column in his personal portfolio. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this post. The fund owned shares of Aixtron, ASML Holding, Keppel, and Schlumberger as of the end of December. Find a full list of the stocks in the fund at the end of December here.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.