The numbers clearly show that fund managers have switched horses. For cyclical sectors, outperformance has given way to underperformance, and vice versa for defensive sectors:
Q2 (to May 23, 2011)
*As of May 23, 2011. Source: Standard & Poor's.
I sense that defensive sectors remain rich in opportunity. Over time, languishing stock prices and steady earnings increases have brought valuations down to levels that are difficult to ignore. Walmart's (WMT) price-to-earnings multiple is in the bottom 10% of its range over that past 10 years; so are those of Quest Diagnostics (DGX) and Constellation Brands (STZ).
It's no surprise, then, that hedge funds are beginning to rediscover the merits of the large-cap blue chips – many of which operate in defensive sectors -- as their appetite for risk tracks the declining expectations for economic growth. That flight to quality also shows up in the outperformance of large caps over small caps for the second straight month. (My Foolish colleague Matt Koppenheffer isn't on board. He explains why you shouldn't buy blue chips.)
Resurgent sovereign debt woes in Europe, slower growth, and the uncertainty linked to the end of QE2 could all be catalysts that force the market to revalue defensive stocks. Since that process is only beginning, stock pickers will find opportunity in these sectors. Even as this rotation into defensive sectors begins, there's no reason to exclude cyclical stocks wholesale. JPMorgan Chase (JPM) at 8.4 times forward earnings? Cyclical or not, that's got to be worth a look.
The Motley Fool owns shares of Walmart Stores and JPMorgan Chase. Motley Fool newsletter services have recommended buying shares of Quest Diagnostics and Walmart Stores, and recommended creating a diagonal call position in Walmart Stores. Try any of our Foolish newsletter services free for 30 days.