Tuesday, January 24, 2012

Sector Rotation Utilizing Cyclical and Secular Investments

Jim Cramer's book "Real Money" discusses rotating one's portfolio through different investments based on multiple (price to earnings ratio) contraction and expansion. He also talks about secular stocks versus cyclical stocks. I would recommend that everyone reads the book for some great tips. He even includes a chart to show when to get in and out of certain investments to maximize the growth of your portfolio. He says that the economy follows specific patterns that can be tracked. Cyclical stocks go along with the economy. When the economy is good, people will buy discretionary items or luxuries. Cadillac will probably sell more cars when the economy is strong and people have money. Secular stocks on the other hand, do well no matter what the economy is doing. People will buy soap and detergent even if the economy is poor. You can rotate investments between cyclical and secular booms. We will pay a higher multiple to earnings for the growth of a secular company than for the growth of a cyclical company. One can’t be deferred, one can. Many people like to invest in secular stocks such as Procter and Gamble (PG), Johnson and Johnson (JNJ) and Kimberly Clark (KMB) since they pay a good dividend and they are companies that sell products that are widely used by the average consumer. Sector rotations: Depending on the state of the economy, you should buy or sell certain stocks at certain times. These will be either cyclical or secular investments. You want to buy based on multiple expansion and sell based on multiple contraction. This is tied into E x M = P. Earnings x multiple (P/E ratio) = price per share

In a recession the stocks with the biggest multiple expansions are the secular investments, such as P&G. When P&G peaks, get into a cyclical stock. When the fed cuts interest rates, get into something discretionary. Purchase cyclicals when the M is highest. Sell non-cyclicals when the M is highest.

PG was $44 when market bottomed out in March 2009. 9 months later it was $62. Low price times higher multiple will equal same earnings.

When times are bad, buy something like PG which is non-cyclical. The earnings will be good even in bad times. The E will be good and the M will contract. As things turn around, the M will expand, making it more expensive. A higher multiple will be paid for secular or non-cyclical stocks.

Before times get good, get into something cyclical like MYG (Maytag) or Dow (DOW) (smokestack stocks), since lowering interest rates will raise their earnings and the multiple will expand since people will pay more for it. On the low end of the cycle, the cyclicals will be cheaper since the earnings will be smaller.

The above information is a summary of principles from Jim Cramer's "Real Money". Investing can be risky, so do your homework or hire a professional before trading securities.

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