Bill Jamieson: Rotation offers new way to find sweet spot

GlaxoSmithKline fits the defensive criteria within rotation. Picture: Getty
GlaxoSmithKline fits the defensive criteria within rotation. Picture: Getty
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WHEN lunching at Edinburgh’s La Bruschetta last week with one of the city’s most personable and attractive stockbrokers, there came that moment when I had to look straight into her hazel-brown eyes and pop that most pressing question of the hour: are you ready to rotate?

Rotation is now all the rage, at least among some people. This is the switching of an investment portfolio from one sector to another – in this case from defensives to “cyclicals”, companies that stand to benefit from an economic upturn. Whether driven by fresh macro-economic data, a spate of corporate news or a change in investor psychology, sector rotation can prove a most rewarding way of positioning your investments – assuming you get it right.

For a year or more, the consensus view has been strongly biased towards defensive sectors such as utilities, pharmaceuticals and tobacco. Large capitalisation companies with a higher-than-average dividend yield and a record of regular dividend increases have been specially favoured.

This positioning has generally worked quite well. Defensive shares are not immune to shock and volatility – witness BP and more recently Tesco – and many will find the risks in even such a relatively sheltered sector too much to take on. But, amid one of the stormiest years for Western economies for decades – with the unfolding sovereign debt crisis in the eurozone and much of the developed world now flirting with, if not actually in, recession – defensive positioning has made sense.

But market moods change quickly. The UK stock market has got off to a stunningly strong start in 2012 – in fact it has seen its best January performance for 15 years just when investors were hunkered down in gilt-edged stock, fixed-interest holdings and defensive shares awaiting the “Great Eurozone Armageddon”.

But in this latest market rally – which has swept the FTSE 100 index within a whisker of 6,000 – last year’s most popular sector has been left behind. And despite all the pressing worries about debt de-leveraging, government spending constrained by deficit reduction, austerity programmes and consumer spending flat to falling it is the biggest and most resilient companies that have trailed. The FTSE 100 index is up 2.1 per cent, the mid-cap FTSE 250 index has returned 6.7 per cent and the small cap index has stormed ahead by 8.1 per cent.

So, is it time for sector rotation and for riding the cyclical surf? Even before the main course arrived, it looked as though I was already behind the curve.

Not only was this rotation into those sectors likely to benefit from a cyclical upturn well underway, but some market gurus were warning that it was already starting to peter out. By the time it got to the ice cream, I’d be back into consumer staples and Unilever.

But surely sector rotation has to be right, given that the market seeks to read economic reality 12 to 18 months ahead? Investment gurus at Nomura argue the case for momentum and rotation given that the valuation gap between the 2011 sector winners (defensives) and losers (cyclicals) has become too extreme.

There’s another powerful argument. In America, Europe and the UK, central banks are pumping in money at a phenomenal rate through programmes of quantitative easing and, in the eurozone, more than €500 billion (£416bn) pumped in by the European Central Bank through its Long-Term Refinancing Operation (LTRO) with more set to come.

Worrying though all this is for what Jeremy Batstone-Carr at Charles Stanley calls “deep thinkers” – those fretting about a world increasingly reliant on monetary expansion at the core – relax. From an investor perspective, “the trend is our friend”.

Monetary policy is specifically designed to encouraging institutions to move along the risk curve and buy equities with the cash from their sales of gilts. What could possibly go wrong?

There are several problems that come with this view. First, in America, the latest non-farm payrolls data may have been markedly better than expected but the market is also having to contend with a slew of profit warnings. And equity ratings need to reflect the real earnings experience of companies. Second, how resilient will markets be when these money infusions cease or are moderated?

And third, Western economies still face years of debt pay-down and de-leveraging. Growth prospects are going to be constrained for years ahead even assuming the latest purchasing managers index (PMI) confidence surveys have turned out better than feared. Investment is a marathon, not a sprint.

Batstone-Carr raises another salient point in his latest excellent note. It is that the investment world since the great financial paroxysm “everything, everything has changed”. Previous medium- to long-term investment strategies are no longer applicable. In a world dominated by debt, the notion that “normal” cyclical upturns will continue to apply cannot be relied upon. The dynamics of economies and markets have quite changed from the circumstances that applied prior to 2007-8.

Here my hazel-eyed stockbroker and my man at Charles Stanley are at one with what Bill Gross at Pimco has dubbed the global quest for “return of capital” – investors on the hunt for likely share buybacks, attractive dividends and underleveraged companies. Investors should not chase a rally that may prove to be no more than a temporary correction brought about, not by a change in fundamentals but by desperate central bank money-pumping. UK companies fitting the defensive criteria include AstraZeneca, BAT, Centrica, GlaxoSmithKline, National Grid, Vodafone and that ultimate provider of my ice cream dessert: Unilever.

Rotation? Not quite tonight, Josephine.