NEW YORK (CNN/Money) -
If the term "double dip" makes you chuckle and think of an episode of "Seinfeld" instead of filling you with feelings of dread, then you are probably betting that the economy is in the process of recovering.
Although the Federal Reserve changed its bias on Tuesday, saying that risks are now weighted more towards economic weakness, and some pundits are predicting a double-dip recession – another economic downturn before a sustained recovery – there is still a sizable camp of market followers who think the economy is improving. (For more about the Fed, click here.)
With this in mind, there are ways for investors to position their portfolios for an eventual rebound. Typically, stocks in the industrial, basic materials, financial and retail sectors are among the first to emerge from an economic slowdown. This was the pattern we saw earlier this year.
In the first quarter, there was more optimism about an economic rebound and the so-called "early cycle" stocks did well. For example, Caterpillar was up 7 percent in the first quarter and shares of DuPont gained 11 percent.
But this summer, a renewed focus on corporate accounting scandals and negative economic data have spooked investors. As a result, many of the early cycle stocks have taken a hit. And that has created some buying opportunities, especially since their outlook still seems relatively strong.
The song remains the same
According to First Call, earnings growth in the financial, technology, basic material, and consumer cyclical sectors (which includes retail) is expected to be higher than earnings growth for the S&P 500 in the third and fourth quarters.
Tobias Levkovich, senior U.S. institutional equity strategist for Salomon Smith Barney, says that industrials and basic materials look cheap and should be among the first group to exhibit signs of earnings improvement. Levkovich says he looks at the stocks mainly on a relative price-to-sales basis – that is compared to the price-to-sales ratio of the S&P 500 – as opposed to earnings, since earnings tend to be extremely volatile for industrials.
Based on this metric Levkovich says industrial stocks are trading at about a 30 percent discount to where they were between 1985 and 1997. He argues that valuations from the late 1990s and 2000 should be discarded since the overall market was trading at a rich valuation.
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Among the companies that Levkovich likes the most are steel producer Nucor (NUE: Research, Estimates), building products maker Louisiana-Pacific (LPX: Research, Estimates) and farm equipment manufacturer Deere & Co. (DE: Research, Estimates), which reported better-than-expected earnings Tuesday morning. Salomon Smith Barney owns more than 1 percent of the shares of each company and has done investment banking for Deere and Louisiana-Pacific within the past 12 months.
Looking at financials, Bob Millen, co-manager of the Jensen fund, says that credit card company MBNA (KRB: Research, Estimates) is looking like a good bet. He thinks the stock has been unfairly punished due to problems at competitors Providian and Capital One, which have more aggressively targeted riskier borrowers.
Since he is not expecting the economy to fall into a double-dip recession, Millen says concerns about MBNA being affected by a wave of defaults are overdone. The stock has fallen nearly 20 percent this year and now trades at just 11 times 2003 earnings estimates, well below its expected earnings growth rate of 17 percent.
Health care may buck a historical trend
But some sectors that are typically viewed as more defensive in nature are also expected to perform well. Wendell Perkins, manager of the JohnsonFamily Large Cap Value and JohnsonFamily Small Cap Value funds, says that because of the market's overall weakness, the rules about what types of companies should benefit from an economic recovery don't apply.
To that end, Perkins has been buying some healthcare and consumer staples stocks lately, including generic drug company Alpharma (ALO: Research, Estimates), medical device maker Theragenics (TGX: Research, Estimates) and tobacco merchant Dimon (DMN: Research, Estimates). "People tend to think of health care and consumer staples as defensive stocks, but they failed miserably as defensive plays during the latest recession," he says.
Of course, health care stocks, particularly large pharmaceutical companies, have had legitimate reasons for underperforming. Concerns about patent expirations and the lack of new blockbuster drugs have held the stocks back.
But for this reason, valuations for the health care sector are not nearly as high as they usually tend to be during the early stages of an economic recovery. Millen says he's added shares of drug and medical device maker Johnson & Johnson (JNJ: Research, Estimates) to his portfolio recently, saying that the stock has not been this cheap in a while.
Subodh Kumar, chief investment strategist for CIBC World Markets, also likes large drug companies and says that with many pharmaceuticals trading at about 15 times 2003 earnings estimates, much of the bad news is priced into the stocks. Drug stocks tend to trade at a premium to the market and are now trading at a slight discount to the S&P 500.