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Investors In Cyclical Stocks Start To Get Picky

--Morgan Stanley Cyclical Index nears pre-crash levels after 17% year-to-date jump --History suggests cyclicals have more room to run, as they tend to rise with employment --With the 2012 run-up, investors are increasingly discriminating in cyclicals selection By Alexandra Scaggs Of DOW JONES NEWSWIRES NEW YORK -(Dow Jones)- Cyclical stocks, geared to outperform in good economic times, have been on a tear this year, and the historical link between cyclicals and declining unemployment levels suggests there is room for further gains. But after the run-up, investors are becoming increasingly selective about their cyclical picks. The Morgan Stanley Cyclical Index, or CYC, which includes Citigroup Inc. (C), Ford Motor Co. (F) and this year's standout Sears Holdings Corp. (SHLD), has gained 16.6% this year. The value of the index has more than doubled since 2009, and it is nearing its pre-crisis level. Sears has soared almost 118% since the start of the year, far beyond the rest of the pack. The group's second-best performer is Whirlpool Corp. (WHR), up 57% so far this year. That rise has led some analysts to wonder if the sector's rally is wearing out. For example, Morgan Stanley in a recent note recommended that investors move into stocks with more historically consistent return on equity. Returns on cyclical stocks vary more, wrote Adam Parker, Morgan Stanley's chief U.S. equity strategist. He added that, while the sector is "modestly attractive," he recommended that investors shift to a defensive exposure, with companies such as utilities company Sempra Energy (SRE) and General Dynamics Corp. (GD). Parker was the most pessimistic of the big bank strategists in his 2012 stock-market forecast. Yet, if the recovery following the 2001 recession is any indication, the CYC index still has room to grow. Starting in 2002, the CYC fell 25% and took about a year to rebound to its pre-recession levels. After that, as unemployment steadily fell, it rose an additional 89% until the next crash starting in September 2008. Even discounting 2007's pre-crash euphoria, the index posted solid gains, rising 51% by the end of 2006. Investors said they are sticking with cyclicals--but they aren't going all in. Pat Dorsey, director of research and strategy for the $500 million Sanibel Captiva Trust Co., said he is bullish on cyclical stocks, since last year's market volatility drove up the price of downturn-resistant defensive industries. So instead of playing defense, Dorsey said, Sanibel is looking for companies that have the ability to raise prices ahead of inflation and higher operating expenses, such as energy, without losing income. He named Johnson & Johnson (JNJ) and business-software giant Oracle Corp. (ORCL) as examples. "It's a market where people have to be more confident in what they're buying," said Brian Jacobsen, chief investment strategist with Wells Fargo Funds' investments group. "You need to make sure that the companies you're investing in won't be hurt too much by oil prices." David Sowerby, portfolio manager for Loomis Sayles, is paying more attention to specific companies as well. "There has been a greater separation of good versus mediocre companies, and that's very beneficial to the market," he said. The firm now has a "modest" cyclical tilt within its $50 billion of equities under management, and is concentrated on high-quality franchise stocks. "It has to be supported by individual company merits," he said. Investors aren't going defensive, by any means. The Philadelphia Utility Sector Index has fallen 3.3% this year. And if there is any pullback or correction in the markets, Jacobsen said, he thinks investors will pile into cyclical stocks. "This can go higher," he said. "There's nothing wrong with pocketing some profits and waiting for some event to drive prices lower." -By Alexandra Scaggs, Dow Jones Newswires; 212-416-4125;

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