What to Do When Everything Rallies

November 6, 2008  

It’s no wonder stocks fell Wednesday. Everything had already rallied.

After a bruising September and most of October, the equity markets went on a six-day run beginning October 28 that lifted the major indexes by at least 17.7% before the market finally succumbed to selling pressure Wednesday. This period was notable for the lack of a truly bad day, as declines in the indexes were modest throughout.

More striking was the fact that the activity had a communal “up with stocks” quality to it, as all major Standard & Poor’s sectors put together strong advances. Some were naturally better than others — the energy sector gained nearly 30%, while the health-care stocks rose a mere 10.4% — but the rising tide truly lifted all boats in this brief flurry of optimism.

“The market threw everything away in October, at least until the very end,” says Bill Stone, chief investment strategist at PNC Wealth Management. “We haven’t really had a bad day — [Wednesday] was about as bad as it’s gotten at any one point…a little bit of the weight has lifted.”

The question, of course, is: What now? With major sectors all receiving a boost after weeks of forced selling and panicked action, investors are left to pick through and try to see what will sustain strength, and what will not. Interestingly, some advisors are looking at those that were among the more sluggish in the last week-plus — defensive areas such as consumer staples and health care names.

The SPDRs Select Sector Consumer Staples fund, which tracks the S&P’s consumer staples sector, gained 11.8%, a steady gain in line with the utilities sector, which rose 12.7%, and the health-care sector. All have been typical plays for those worried about the future prospects for the economy.

“Traditionally, you think health care is vulnerable under a Democratic administration,” says Bill Schultz, chief investment officer at McQueen, Ball & Associates in Bethlehem, Pa., referring to the election of Barack Obama to the presidency. “But they’ve been beaten down so badly it’s tough to make a case against health care with P/E’s in the upper single digits.”

Mr. Stone says consumer-staples names, particularly those with a global reach, are likely to benefit from the decline in costs for raw materials used in production as economies take time to recover, and inflation recedes as a concern for some time.

At times such as this, investors often retreat to value-oriented approaches, particularly looking at those with low price-to-earnings ratios, but Andrew Lapthorne, strategist at Societe Generale, warns that this strategy can be a trap when analysts have a glum outlook on earnings.

“High levels of earnings uncertainty presents a good environment for value strategies, no doubt because this higher risk environment depresses prices and creates the value opportunities in the first place,” he writes. “However, rising earnings uncertainty will continue to erode confidence in the underlying earnings, hence the risk of a low P/E strategy continuing to underperform.”