Rebound has to prove itself

When the U.S. economy appears on the verge of rebounding -- as it does today -- investors tend to gravitate toward economically sensitive stocks, which stand to benefit from improving financial conditions.

Often, this leads them to traditional growth sectors, like technology, materials and consumer discretionary stocks, which include retailers. Economically cyclical companies in areas like financial services and manufacturing may also seem appealing.

True to form, these five sectors have been among the best-performers in the Standard & Poor's 500-stock index so far this year.

And, since March, each of these categories has surged more than 70 percent. That's roughly double what many of these sectors have averaged in gains in the first 12 months of new bull markets since 1949, according to S&P.

"Certainly, we've seen a tremendous run-up in the most economically sensitive stocks," said Jeffrey Kleintop, chief market strategist at LPL Financial in Boston.

Now, some market strategists are beginning to wonder whether these stocks have already had their day.

At the very least, prices of the most economically sensitive groups already reflect expectations of a robust recovery.

For example, the price-to-earnings ratio for the materials sector of the S&P 500 (which includes companies like Dow Chemical and International Paper) has more than doubled over the past year, to 36 from 17, according to S&P. This figure is based on 2009 operating earnings.

But Wall Street analysts are forecasting a 99 percent rise in earnings for that category in 2010. Based on these projections, the so-called forward P/E of the materials sector is a much more palatable 18.

Analysts are similarly betting on huge earnings recoveries in 2010 for several other economically sensitive groups, like financials.

Kleintop says these earnings expectations aren't necessarily unreasonable.

"But you do need to see some follow-through here," he said.

"You can't just see higher and higher valuations on the hope for more growth. At some point, you have to see companies, particularly in those sectors that have risen the most -- like consumer discretionary, technology and industrials -- deliver on those earnings expectations, or the market will be disappointed."

That test is beginning, with the start of the third-quarter earnings season.

Christian Anderson, an associate portfolio manager at Russell Investments in Tacoma, Wash., said the rally that started in early March might be entering a second phase. In the first stage, the stocks that fared best were economically cyclical shares and those that had been beaten up in the bear market.

Now, with valuations starting to come into question, investors may want to turn their attention to what Anderson calls "organic growth" stocks -- shares of companies that don't rely entirely on a robust recovery to expand their business and profits.

He said technology might be an area to consider. Many tech companies don't have any debt on their balance sheets, and tend to enjoy healthy cash flows. And unlike, say, retailing, this sector doesn't require a quick consumer recovery, he said.

What's more, technology is a growth sector in which valuations still look reasonable.

Jack A. Ablin, chief investment officer at Harris Private Bank in Chicago, says that growth stocks in general have been outperforming the rest of the market for the past couple of years.

"The group is beginning to look expensive and tired," he said.

Still, tech stocks have generally not seen their valuations rise, he added. Indeed, the average P/E ratio for tech companies in the S&P 500 is now 22.2, based on 2009 operating earnings. That's lower than it was in the second quarter this year -- and well below the sector's median P/E of 30.5 since 1995.

Tech is the sector most favored by investment managers now, according to a survey by Russell Investments. Health care comes in second. While health care stocks don't depend on a strong recovery, they are still traditionally considered growth investments. And they're currently cheap. The P/E for health care stocks in the S&P 500 is 12.8 -- about where it was a year ago.

The consumer discretionary sector, another traditional growth area, may be worth a look, although it is dependent on a rebound not just in the economy but also in consumer spending. But earnings here have already started to improve -- up 64 percent this year.

As in the technology sector, valuations for these stocks have already started to fall even as stock prices have soared. So if the overall market were to plunge, these stocks' more modest prices might cushion their fall.