CBSMarketwatch: Riding the Rally - How to Make Money in the Bull Market's 2nd Year

Ned Davis of Ned Davis Research last week wrote to clients: "The disparity between hope on Wall Street and malaise on Main Street continues. I have never seen anything like it. Perhaps it is dangerous to draw a conclusion, but for now I think it is consistent with a neutral to mildly bullish trading strategy."

• Happy birthday, baby bull. So far you're one for the storybooks. What can investors expect in Year Two? If history is a guide, the second verse will echo the first. One year ago this Tuesday, the U.S. stock market started to crawl away from its worst bear-market mauling in eight decades, where the benchmark Standard & Poor's 500-stock index lost more than half of its value. Through March 4, the S&P 500 is up 66% since its March 9, 2009 low.
• The market's performance so far has mirrored a pattern common to every bull market since 1949, according to Standard & Poor's Equity Research. In a rally's first year, small-cap and midcap shares typically beat large-cap rivals, though a rising tide lifts all boats. The average first-year gain for small-caps is 48%; for large-caps, it's 32%. In addition, low-quality issues generally outdo high-quality as investors get more comfortable with risk. The worst become first, and economically cyclical sectors outperform defensive ones. (that very much happened in 2009)
• During the second year, historically, stocks keep rising -- though not as powerfully, said Sam Stovall, chief investment strategist at S&P Equity Research. Small-cap and midcap stocks continue to outperform both large-caps and the S&P 500, which still do all right themselves, and higher-quality issues with stable and growing earnings trump low-quality names. (that had been the case up for the past few months until about 10 days ago, when speculators began rushing into low quality specs once more)
• Year Two's best sectors have been cyclical plays: consumer discretionary, financials, technology, and industrials. (other than financials this has been the place to be in 2010) More defensively positioned sectors improve as well, and one wild card to take note of this year is health care.
• This is good news for investors -- if there is a second year for the bull. Some market observers including analysts at Ned Davis Research Inc. believe stocks are in a "cyclical bull" market within a "secular bear" -- something akin to the frustrating period between 1966 and 1982 when the market swung between deep depressions and manic highs but never really broke out of a trading range. If that's so, said Ed Clissold, senior global analyst at Ned Davis Research, then the bull would have an average lifespan of about 17 months, which would mean the market's music could stop in late summer.
• "First-year bulls tend to recover an average of 84% of what they lost in the entire bear market," he said, noting that this bull run has retraced about half of the loss. "So you could say that on a recovery basis, we have more room to go." Moreover, since 1949 none of the 10 prior U.S. bull markets has ended in its second year -- the shortest was 26 months beginning in 1966. Since 1932, the median length of a bull market has been 50 months, according to S&P. That said, between 1932 and 1947, four of the five bulls fizzled in two years or less.
• "The second year is very important because it gives you a clue for the sectors and industries that are likely to perform for several years as long as the economy is growing," said Ed Yardeni, president of Yardeni Research Inc.
• Yardeni also favors the consumer discretionary sector, where corporate managers "have cut back a lot of capacity." Plus, the recession torpedoed many weak players, so competition is scarcer. Said Yardeni: "The survivors have more business than they can take on." Consumer discretionary stocks outperform the S&P 500 two-thirds of the time in the bull's second year, gaining 18% on average.
• Health-care stocks typically outperform in the third year of a bull market, as investors lose some of their appetite for risk. But Johnson likes the picture he sees for the health-care sector. "In the second year, some of the defensive sectors start to get better," Johnson said. "I wouldn't be surprised to see health care be a good performer."