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Economic Sector Rotation after ISM Peaks:

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Market Comment . . . If you believe the Fed will slow down the economy via raiding interest rates. Then you have to read this.

The flowers are not the only thing blooming this spring as a string of friendly announcements seems to suggest that the economy is blossoming as well. Indeed, almost every indicator of activity has come in on the high side of expectations during the past month, and first-quarter earnings season has been nothing short of spectacular. Regardless, the stock market managed to lose ground during the past month! While interest rate fears certainly contributed to investors’ uneasiness toward equities, we believe the real story lies in the loss of momentum in leading indicators of the economy such as the ISM. This development usually coincides with a market transition, and this time appears to be no exception.

The ISM is one of the most useful macro indicators for portfolio strategy. Around since the 1930s, the ISM is both time tested and timely in its release. While the ISM’s April reading of 62.4 is consistent with very strong growth in the economy, it is equally important to note that the indicator declined slightly last month and still remains below the January posting of 63.6 — a reading that increasingly appears to be the cycle high point. Going forward, interest rate trends in the global economy suggest that monthly declines in the ISM could become a more common occurrence. Indeed, a look at the chart above shows that the momentum in international short-term interest rates typically leads other leading indicators such as the ISM. At this juncture, this forward-looking relationship argues that we are likely in the midst of an important transition.

The equity market also appears to be at a crossroads. Indeed, cyclical sector leadership, evident throughout most of 2003, has begun to wane in recent months. The fact that this ebb in cyclical leadership began pretty much on cue with the peak in the ISM is no coincidence, in our opinion. As such, the investment conclusion suggested by the macro backdrop is clear: Noncyclicals are the way to go! A number of other elements also argue in favor of noncyclicals. These include the stretched relative valuation of cyclicals versus noncyclicals; the presidential election year, which typically favors noncyclicals; and a quantitative model, which currently displays a preference for the more stable segments of the market. The body of the evidence supporting noncyclical leadership going forward is growing larger by the day. Accordingly, some investors might want to take a defensive posture and overweight noncyclical sectors such as health care and staples, and underweight the more cyclical segments of the market like industrials, materials, and technology.

In order to understand why a transition is occurring in financial markets, we have to first study the events that have led up to it. After delivering significant returns in 2003, the stock market has moved sideways since January. The market’s failure to make headway is largely attributable to the peaking of many leading economic indicators in recent months. Accordingly, expect to find historical evidence of the negative impact of a turn in leading economic indicators on financial markets. Indeed, analysis shows that once leading indicators come off the boil, investors can expect a loss of momentum in equity market returns.

Historically, a peak in cyclical pressures has typically brought with it more measured gains for the S&P 500. Indeed, the equity market tends to perform much better in the 12-month period leading up to a peak in leading indicators (up an average of almost 15%), when economic momentum is accelerating, than in the year following a peak in leading indicators (down on average about 3%), when momentum begins to wane. The current easing of cyclical pressures sends a strong message — that investors should expect a much

different stock market environment over the next 12 months than they’ve seen in the past year.

The historical performance of the S&P 500 surrounding past post-60 peaks in the ISM can provide useful insights as to what is likely to lie ahead in the coming year. Indeed, it is interesting to note in the table above that most of these periods have seen a solid rise in the S&P 500 in the year leading up to a peak in the ISM, followed by a decline or severe loss of market momentum in the year after. One notable exception is 1987, which was distorted by the stock market crash. Putting this aside, the best performance the S&P 500 has delivered in the 12-month period following an ISM peak has been a paltry 3%.

A turning point in cyclical pressures can also bring about a change in stock market leadership. Indeed, investor focus usually shifts away from non-dividend-paying stocks to the dividend-paying universe with a trend change in economic momentum. In that regard, a look at the historical record will reveal that the outperformance of dividend-paying stocks in aggregate has been almost 5% relative to their non-dividend-paying brethren in the 12-month period following a cyclical peak in the ISM Index.

A transition in cyclical pressures can also lead to a change in investor preference in the area of company quality. Indeed, a rising ISM Index usually brings with it strong performance for low-priced/high-beta stocks (commonly referred to as low quality). This trend typically comes to an end coincidentally with a peak in leading economic indicators, such as the ISM, at which time high-grade companies are preferred. Therefore, we would not be surprised to see quality companies gain investor interest in 2004.

While a peak in leading indicators of the economy can influence overall market returns, it is at the sector level that this situation has the most important implications. The bullish case for cyclicals in 2003 was predicated on the fact that leading economic indicators were at low levels and rising — an ideal condition for cyclical sectors. In February 2004, with many indicators sitting at 20-year historical highs, it is time for investors to consider the implications of a pullback in cyclical pressures. At that time, analysts advised investors to reduce their cyclical sector weighting to market weight and to increase their noncyclical sector weighting to market weight.

In early March, analysts advised investors to take a further step toward a less aggressive portfolio by changing the mix of industry recommendations within each sector, placing emphasis on this offering stability. Following weeks of indecisive market action, analysts are now suggesting that investors take the additional step of raising their noncyclical weighting to overweight and of reducing their cyclical weighting to underweight. Indeed, cyclical sectors tend to dominate in the year leading up to a cyclical peak, and noncyclicals take over in the subsequent 12 months. Noncyclical leadership in the period following a cycle peak typically lasts about 23 months. In other words, it is not too late to take action since this is likely still the first inning of noncyclical leadership.

Health Care & Biotech average 33.5% returns 100% of the time following peak in ISM

Consumer Staples average 19.0% returns 100% of the time following peak in ISM
Financials average 4.7% returns 75% of the time following peak in ISM

Utilities average 4.8% returns 50% of the time following peak in ISM
Telecom average 2.2% returns 50% of the time following peak in ISM

Industrials average -4.2% returns ollowing peak in ISM

Consumer Discretionary average -4.4% returns 50% of the time following peak in ISM
Energy average -5.2% returns 50% of the time following peak in ISM

Technology average -9.5% returns 25% of the time following peak in ISM

Materials average -12.2% following peak in ISM

As the table above indicates, the sectors that consistently outperform once cyclical pressures recede are health care and consumer staples, both delivering double-digit relative returns on average — a full 100% of the time. Conversely, industrials and materials have consistently underperformed the market once cyclical pressures come off the boil. All the while, financials, utilities, and telecom have on average managed to outperform the market, albeit their performance has been less consistent than that of health care and staples.

The aforementioned three-step process toward noncyclical positioning has been gradual, in line with the historical pace at which this transition typically occurs. Indeed, let us remind readers that we maintained a pro-cyclical stance for the better part of the 15 months leading up to February. During that time, we favored industrial stocks, particularly the machinery segment, since these stocks are strong beneficiaries of accelerating economic momentum. The downgrade of cyclical segments and shift in industry mix from cyclical overweight to more noncyclical segments took several months. Now that the ISM has remained below its January peak for a third consecutive month, it is time to upgrade noncyclical sector weighting to overweight from market weight and to downgrade our cyclical sector weighting to underweight from market weight.

When economic momentum was accelerating for the better part of 2003, along with industrials, the market favored the materials and technology sectors. At this juncture, however, noncyclical sectors such as consumer staples and health care are at the top of the market list and offer a much more compelling risk/reward profile. As a general rule, focus on industry groups that are less vulnerable to the economic cycle — i.e., groups that are better positioned within their sector as economic pressures continue to wane. For instance, investors should reduce exposure to the most cyclical segments, such as metals, semiconductors, and machinery. For those who wish to maintain a cyclical position, suggest segments such as chemicals, software, and restaurants, all of which are “somewhat” less vulnerable to a decline in cyclical pressures.

Historically, the materials and industrials sectors have demonstrated a particular vulnerability to a turning point in leading indicators of the economy. Indeed, over the past 20 years, both of these cyclically-leveraged sectors have shown a zero batting average in terms of performance in the 12-month period following peaks in the ISM. In other words, neither of these sectors has ever outperformed in the year past a high mark in the leading indicators such as the ISM Index. Moreover, during these periods, materials and industrials delivered relative returns on average of negative 12.2% and negative 4.2%, respectively. As such, an overweight in either of these sectors at this stage is tantamount to bucking history.

The technology sector, on the other hand, has shown the ability to buck the economic cycle at least once. Indeed, in aggregate, tech stocks have managed to outperform the market in one of the episodes following the last four rollovers in the ISM. Notwithstanding this, a close look at performance trends shows that tech has typically underperformed more significantly than industrials. In other words, while it’s bucked the trend once, on average, tech has been a worse place to be than industrials. In fact, the average performance of the technology sector following a peak in economic momentum has averaged about negative 9.5%, whereas industrials has averaged negative 4.2%. Certainly, beta is another factor one must consider with technology.

Unsurprisingly, the results for the discretionary sector are somewhat mixed, showing vulnerabilities as well as opportunities. Since the sector is essentially a hodgepodge of different industry groups, some segments have never outperformed following a peak in cyclical pressures, while others have offered good opportunities. For instance, durable goods segments such as household appliances and auto

parts & equipment have never outperformed during the last four periods of waning cyclical pressures. Meanwhile, segments such as hotels and auto manufacturers have defied the trend on one occasion, although both have underperformed significantly.

Consistent Underperformers Following Cycle Peak

% of Time Average Relative

Outperforming Performance

Materials 0% -12.2%

Steel 0% -27.7%

Gold 0% -26.2%

Diversified Chemicals 0% -15.4%

Paper Products 0% -15.0%

Commodity Chemicals 0% -14.7%

Forest Products 0% -10.1%

Aluminum 25% -17.7%

Containers & Packaging 25% -8.6%

Diversified Metals & Mining 25% -8.3%

Paper Packaging 25% -8.3%

Specialty Chemicals 25% -3.3%

Industrials 0% -4.2%

Employment Services 0% -31.6%

Airfreight & Couriers 0% -22.6%

Construction & Farm Machinery 0% -17.6%

Building Products 0% -14.0%

Office Services & Supplies 0% -12.3%

Machinery 0% -12.1%

Electrical Equipment 0% -8.8%

Industrial Machinery 25% -11.5%

Construction & Engineering 25% -4.4%

Commercial Services & Supplies 25% -4.0%

Industrial Conglomerates 25% -0.3%

Technology 25% -9.5%

Computers & Peripherals 25% -20.9%

Semiconductors 25% -12.4%

Electronic Equipment 25% -12.0%

Energy 50% -5.2%

Integrated Oil & Gas 25% -7.6%

Consumer Discretionary 50% -4.4%

Household Appliances 0% -21.9%

Auto Parts & Equipment 0% -19.0%

Catalog Retail 0% -18.6%

Apparel & Accessories 0% -18.5%

Hotels 25% -16.3%

Auto Manufacturers 25% -10.8%

Home Furnishing 25% -8.3%

Apparel Retail 25% -7.7%

Consistent Outperformers Following Cycle Peak

% of Time Average Relative

Outperforming Performance

Health Care ex. Biotech 100% 33.5%

Pharmaceuticals 100% 38.2%

Distributors & Services 100% 36.6%

Equipment 100% 32.9%

Supplies 75% 17.8%

Consumer Staples 100% 19.0%

Food & Drug Retail 100% 24.0%

Beverages 100% 15.1%

Food Distributors 75% 27.2%

Brewers 75% 14.4%

Food Products 75% 10.4%

Packaged Foods 75% 9.8%

Household Products 75% 9.6%

Financials 75% 4.7%

Diversified Financial Services 100% 12.1%

Insurance Brokers 75% 7.5%

Property & Casualty Insurance 75% 2.8%

Life & Health Insurance 75% 2.1%

Multi-line Insurance 75% 1.8%

Banks 75% 0.4%

Utilities 50% 4.8%

Electric Utilities 75% 6.4%

Telecom 50% 2.2%

RLECs 75% 49.8%

RBOCs 75% 33.8%

Consumer Discretionary 50% -4.4%

Homebuilding 75% 16.3%

Broadcasting 75% 6.9%

Industrials 0% -4.2%

Data Processing 100% 19.4%

Defense 75% 40.9%

Materials 0% -12.2%

Industrial Gases 75% 5.7%