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It's Too Late for Defense and Too Early for Offense

By    |   Monday, 23 July 2012 08:18 AM

With Europe in recession, China slowing and the U.S. economy steadily losing steam, most investors are retreating to defensive positions. 

As evidence, the main flow of investor funds has been moving out of stocks and into bonds, and investor money remaining in the stock market is moving into defensive market sectors.

According to Strategic Insight, investors pulled a net $7.7 billion out of U.S. stock funds in June. This was the fourth straight month of net withdraws and the largest yet this year. In contrast, U.S. bond funds attracted $15 billion in net deposits in June, which marked 10 straight months of net deposits. In the first six months of 2011, stock funds had net outflows of $15 billion, while bond funds had net inflows of about $150 billion. 

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At the same time, money in the stock market has been going into the most defensive sectors.  In the past three months, the top-performing sectors of the market have been two of the most defensive, telecommunications and healthcare. Telecom industry leaders AT&T (T) and Verizon (VZ), as well as most major U.S. pharmaceutical companies, are trading close to their 52-week highs and near post-financial crisis highs. 

The exodus into bonds has pushed yields to historic all-time lows (as bond prices increase, yields fall). The 10-year Treasury now pays just 1.45 percent. However, nothing exemplifies the level of fear in the market and the thirst for safety than the fact that six of the world's highest-rated countries are currently paying negative yields. That means the bonds have gotten so pricey that investors are actually paying the issuer for the right to lend them money. 

In short, it is getting awfully expensive to play defense. 

The herds are no doubt stampeding toward safe haven investments. But following the herd has typically been a poor investment strategy. Perhaps a better investment strategy is the contrarian play. What have investors been shunning?

The worst-performing sector of the market over the past three months, as well as the past year, has been basic materials (primarily companies in metals and mining). Morningstar's basic material group is down more than 20 percent over the past year and 8 percent over the past three months. Fears of a global economic slowdown and decreased global production have made this group an outcast. 

At the same time, however, commodities have been in a secular bull market since early last decade. The falling value of the dollar, as well as growing demand from emerging markets, have sent prices skyrocketing over the past decade. Lately, however, fear and uncertainty have reversed the longer-term trend and the dollar has been strengthening and global commodity demand is slipping.

But this seems to be a temporary reversal, as the long-term catalysts for a falling dollar and rising commodity demand from emerging markets are still very much in place.

It appears that the basic materials sector is in a long-term bull market, like stocks were in the 1980s and 1990s. The past year has been a temporary breather or dip. If someone put money in stocks when the market stumbled, or bought on the dips, during that bull market, they generally fared very well. 

So the answer is simple. Be contrarian and look to basic materials. Invest away from the herds where valuations are much better and a long-term bull market will eventually reward you.

The problem is that is appears to be too soon for such a move.

Uncertainty in the market has seldom been greater. No one really knows the full extent of the European problem. The world economy, as well as the U.S. economy, is unmistakably slowing.  There is also still the tremendous uncertainty regarding the "fiscal cliff" and the presidential election. Many of these problems are political in nature and, therefore, very difficult to predict.  Things could easily get worse before they get better.

It seems that the only near-term catalyst that could drive commodity prices substantially higher is another round of quantitative easing (QE). After all, both QE1 and QE2 helped to drive stock and commodity prices higher. QE3 could be just what the doctor ordered. 

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But Federal Reserve Chairman Ben Bernanke seems very reluctant to enact another round of QE. In fact, the Fed seems unlikely to do another round unless the economy substantially deteriorates from here. In that case, any benefit of QE3 would likely be offset by a worse economy.

While a move toward the most-cyclical sectors of the market will likely pay off eventually, it still seems a little early for the move. 

Investors are in a strange sort of limbo in this environment. It's too late to play defense and too early to play offense.

About the Author: Tom Hutchinson

Tom Hutchinson is a member of the Moneynews Financial Brain Trust. Click Here to read more of his articles. He is also the editor of The High Income Factor. Discover more by Clicking Here Now.

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Monday, 23 July 2012 08:18 AM
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