The Tell: The rally in cyclical stocks has only just begun: Leuthold’s Paulsen

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Investors have grown increasingly confident about the U.S. economy during the past three months, and have dumped previously high-flying sectors like utilities and real estate for more cyclical ones like financials and industrials.

During the past three months, financial stocks have been the best performing sector, as measured by the Financial Select Sector SPDR Fund XLF, +0.56%, which has risen 11.3% over that time, versus a 6.1% rise for the S&P 500 SPX, +0.12%.

But the rotation into cyclical stocks has been incomplete, with consumer discretionary and materials names lagging the market, even as rising bond yields reflect a market that is more confident about future economic growth.

The Consumer Discretionary Select Sector SPDR Fund XLY, +0.51%  has risen only 0.2% during the same period, while the Materials Select Sector Fund XLB, +0.20%  has gained 3.9%.

That may be about to change, according to Jim Paulsen, chief market strategist at Leuthold Group. “Cyclical stocks have had a mixed performance” during the value rotation, he told MarketWatch. Still, “there’s a change a foot with a move away from defense to offense,” he added. “Just look at bond yields rising, commodity prices bottoming and safe have currencies suffering. If that continues, part of all this will be cyclical leadership.”

Nevertheless, one must be cautious when wading into these sectors.

“Cyclical stocks can be difficult to buy,’ he wrote in a recent note to clients. “You usually can’t wait until they show decent price momentum because, by then, their leadership is probably nearing an end.”

“Moreover, the best time to buy economically sensitive stocks is typically when their fundamentals (e.g., earnings or sales growth) are less than stellar,” he added. “Unlike growth stocks, if the fundamentals of a cyclical company are obviously great, it is usually a good time to sell. For similar reasons, conventional valuation gauges are also problematic. Often, the best time to tilt toward cyclicals is when fundamentals are questionable and, therefore, relative valuations are high.”

In other words, if you believe the U.S. economic expansion still has some time to run, now may be the time to bet on beaten down names in the materials and consumer discretionary sectors. “These stocks have stabilized, but haven’t gone anywhere after collapsing,” Paulsen said. “It’s not too late to get in on the trade.”

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