Outlook: Cyclical stocks

THE MUCH trumpeted switch in stock market sentiment from growth to traditional, cyclical stocks may already have run out of steam, judging by the bounce back in technology issues over the last two days. Even so, a quite significant shift in fashion seems to have occurred in recent months. Since the beginning of March, there has been a pronounced run up in industrial and other cyclical stocks across Europe. IT, telecoms and pharmaceuticals have meanwhile fallen behind.

These trends are more pronounced on the Continent than they are in Britain, where the strong pound continues to damage traditional manufacturers, but even here the extraordinarily wide disparity in valuations built up in recent years has begun to narrow. If this helps manufacturers and leads to a more balanced approach to investment, it cannot be anything but a healthy development. But is it going to last?

There are obviously a number of good reasons for going back into cyclicals. The economic outlook is now much better than it was six months ago, while the turnaround in the oil and some other commodity prices has bolstered the view that maybe there's some earnings growth to be had from these companies after all.

In any case, with yields of 6 per cent and upwards and no sign of a dividend cut in sight, let alone deeper rooted financial problems, quite a lot of these stocks have begun to look exceptionally good value.

So there is no quarrel with the idea that cyclicals have been oversold and demand a rerating. More contentious is the belief in some quarters that the growth stocks of the IT, telecoms and life science sectors have had their day. Some areas of the IT industry in particular have become absurdly overhyped and overvalued - most notably anything to do with the internet. Even so, most of the factors that have driven up share prices in these sectors still apply.

In a low inflation, low growth environment, any industry or company with good earnings growth potential has a scarcity value and must therefore command a corresponding premium. Obviously, there's going to be a reckoning if they fail to deliver, but in many cases, the horizon in expectations is so distant that this doesn't look likely to happen any time soon.

What is certainly true, perhaps sadly, is that the shifting sands of sentiment have again demonstrated the investment advantages of indexation and the perils of stock selection. There are a few active fund managers, most notably Phillips and Drew, that have chosen to stick with value methods of stock selection through thick and thin, and they will have had the full benefit of the recent uplift in cyclicals. But most have not, choosing instead to follow the herd into the growth sectors. Relative to the market, they will have done quite badly so far this year.

However, those invested across the market as a whole will have barely noticed the rotation effect. What they've lost on the swings, they've gained on the roundabouts.