Important Update On Sector Performances During This Stock Rally

I spend a lot of time crunching data, reading third-party research, and studying market history. And one of my favorite things to watch is the relative performance of the individual market sectors.

Today, I’m going to give you the latest numbers on these important market groups, along with some additional thoughts about second-quarter earnings.

But first, I want to clarify exactly what I mean by “sector” …

If you ask most investors - even many professionals - a stock sector is simply any group of companies that operate similar businesses.

In my book, that’s too broad a definition. Instead, I subscribe to the idea of the ten market sectors as they’re treated in major indexes such as the S&P 500 (^GSPC).

These ten sectors are part of the official Global Industry Classification Standard (GICS). The breakdown is as follows:

#1. Energy - Pretty self-explanatory, but these companies include the major integrated oil companies, drillers, etc. Note, however, that it does NOT include …

#2. Utilities - These are the firms that provide us with basic services like electricity, water, and gas. Many are regulated by the government, though deregulation and consolidation has become a growing trend.

#3. Financials - Everyone from banks to brokerages to insurance firms. You’ve heard a lot about these guys lately!

#4. Consumer Discretionary - The companies that provide things we can generally afford NOT to buy - fast food companies, clothiers, and most other retailers (which I covered in depth two weeks ago).

#5. Consumer Staples - In contrast to the discretionary firms, these companies sell the things we do buy through thick and thin … household products, packaged foods, beverages, and yes, cigarettes.

#6. Health Care - Everybody from the major pharmaceutical firms to medical device makers to health plan providers go here.

#7. Information Technology - Computer makers, software providers, technology service providers, and so on.

#8. Telecommunication services - Whether they do traditional landline phone hookups or just cellular connections, they go here.

#9. Materials - These companies specialize in finding and working with metals, chemicals, timber, etc. Miners, refiners, and other natural resource companies fall into this category.

#10. Industrials - A pretty broad category that includes companies making heavy-duty equipment and other so-called capital goods, along with airlines, railroads, delivery and office services, etc.

Sure, there are other ways of breaking down the groups. And there is plenty of overlap and interconnection between these 10 sectors. But I still find GICS to be the best overall way of organizing the various stocks out there.

What about the different groups within the sectors? Those are individual industries!

Okay, So How Have the Various Sectors Been Acting Lately?

In recent columns, I’ve been voicing concern over consumer spending and how that will impact the overall economy and the more cyclical sectors such as consumer discretionary firms.

But if the recent market action is any indicator, most investors are simply NOT sharing my worry. Take a look …

This chart shows the performance of each individual sector from July 10 through July 23. That about covers the recent stock rally, over which the S&P 500 index gained 11.1 percent.

As you can see, materials, consumer discretionary, and information technology were the three biggest winners.

Note that all three of these sectors are highly cyclical. In other words, they do well when the economy is strong and poorly when the economy is weak.

The fact that these three continue posting strong gains means investors are betting on a quick economic recovery.

But even if things are now less worse … and possibly even bottoming … is such an optimistic rotation into these riskier stocks warranted?

I’m not so sure.

Simply consider what we heard from Microsoft (MSFT) last Friday. The firm said profits sunk 29 percent in the second quarter of 2009 vs. the same period a year earlier.

And it wasn’t just one business unit dragging down results, either. According to the company’s Chief Financial Officer, Chris Liddell:

We’re still in tough economic conditions and we don’t see that getting better in the near term.

Now, there have certainly been some good earnings numbers coming out of other tech companies.

However, Microsoft deals with companies around the world. It sells products that are - at least for now - practically universal. And it’s saying things are bottoming, at best. Not improving.

So is the runup in cyclical shares warranted? More importantly, what happens if we just scrape along the economic bottom for a while?

In my opinion, the less cyclical sectors are still where the best values are in this market, especially once you factor in risk!

What about the financials?

As I said last week, I am looking past the supposed positive second-quarter earnings reports to bigger challenges ahead - including rising loan losses, less government support, and looming legislation that could hobble many firms going forward.

One last thing: Today’s analysis was only based on capital appreciation over a very short timeframe.

If you look at the longer horizon, the results look much different. And as I recently showed my Dividend Superstars subscribers, if you consider total returns - i.e. the effect of changing dividend policies - well, you get a completely different picture entirely!

Hey, if you believe this is it … and it’s all blue skies ahead, then by all means you should be allocating your stock portfolio into July’s big winners.

But if you’re more like me - a little skeptical that we’re going to see a rip-roaring U.S. economy right away - then you still might want to consider favoring the dividend-rich, less cyclical sectors for now.

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