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Weekend Investor

How 2012's top money ideas have fared so far

Reuters

SAN FRANCISCO (MarketWatch) -- As the year began, investors were encouraged to stick with 2011's winners -- chiefly defensive, dividend-paying U.S. stocks that offered safety and income.

What goes around has come around again. Many of the economic and political concerns that plagued global markets in 2011 are even more acute.

In the U.S., investors are increasingly worried about weaker-than-expected second-quarter earnings and when, and if, the Federal Reserve will move to provide the lackluster economy with additional stimulus.

Markets are also tracking the political landscape leading up to November's presidential election. Expect another wrenching battle over the U.S. debt ceiling and fighting on the edge of the so-called fiscal cliff over the scheduled expiration of the Bush administration tax cuts and other spending cuts and additional taxes.

Europe, meanwhile, continues to be a modern-day Tower of Babel, to which investors now can add the sputtering economic engines of China and India.

These and other headline-grabbing issues were on the radar in January when we highlighted 10 investment themes for 2012. At this midyear checkup, what course corrections, if any, should investors make? Read more: 10 money-making investment ideas for 2012.

1. Last year's winners

Six months ago it was clear that the 2012 market climate would favor careful stock selection and prudent stewardship of capital. Advice to stick with large U.S. stocks and to hunt for yield has proved lucrative.

What to do: Global economic growth is an oxymoron at this point. Beef up holdings of large-cap U.S. stocks with solid growth prospects, strong cash flow and a history of hiking dividend payments.

Growth stocks should continue to top value stocks, while large-caps stay ahead of small-caps and U.S. equities outperform Europe. Meanwhile, U.S. midcap stocks increasingly are seen as overbought and overvalued.

The biggest of the big, the so-called mega-caps of the Standard & Poor's 100-stock index (OEX) , in fact are breaking out of a two-year trading range and emerging as market leaders, according to Bank of America Merrill Lynch research.

For example, the 10 highest-yielding stocks in the Dow Jones Industrial Average (DJIA) , the so-called Dogs of the Dow, were up 6.8% for the year through July 11, while the Dow itself rose 3.2%. AT&T Inc. (T) and Verizon Communications Inc. (VZ) are the top-two yielders in the Dow, and also the biggest percentage gainers.

2. Defensive stocks

An emphasis on the return of capital rather than return on capital has not only given investors a solid cushion, but has also made them money. Defensive stocks have been the U.S. market's best performers so far this year. Read more: Defensive stocks trade near 52-week highs.

What to do: The best offense continues to be a good defense, even with strong year-to-date gains in traditionally stable, dividend-rich market sectors within the Standard & Poor's 500 Index (SPX) .

Consumer discretionary stocks rose 11% on average for the year through July 10, while the health-care sector gained 8.5% and consumer staples added almost 8%. Those sectors are still attractive, according to Merrill Lynch. But the outlook is more cautious for the utilities sector, which is up 2.1% on the back of a 15% gain in 2011.

"Valuations are high," said Paul Mangus, head of equity research and strategy at Wells Fargo Private Bank. "We are underweight utilities for that reason. This has the possibility of spilling over; folks have been chasing telecoms and utilities as part of high dividend strategies, and that may put the stocks under pressure."

3. Economic sensitivity

Stocks sensitive to the economy are lagging this year, just as they did in 2011. The energy sector has fared worst, down almost 6%, while materials and industrials stocks are both up about 3% on average.

The one cyclical standout is technology, gaining almost 11% on the year so far.

What to do: On a valuation basis, materials, industrials and energy are cheap relative to the S&P 500 itself, but that doesn't make them screaming buys -- yet.

"These sectors will outperform over time," said Heather Brilliant, vice president of global equity and credit research at investment researcher Morningstar Inc., in a recent report. But, she added, "the issues holding these sectors back -- namely lower commodity prices and weak global demand for commodities -- are likely to continue for the coming quarter."

Technology is different. Remarkably, technology stocks are priced lower than utilities. Technology also trades at a discount to the S&P 500 for the first time since 1996, according to Merrill Lynch. Tech stocks tend to have lots of cash, strong balance sheets and generally good growth prospects, especially among software and services businesses. One caveat: Tech's exposure to Europe is the highest of any S&P 500 sector.

4. Dividend-paying growth stocks

U.S. companies are in the money, and are sharing more of the wealth with stockholders by initiating or raising quarterly dividend payments.

Investors who took the advice at the start of the year to own companies with dividend yields above the 10-year Treasury have done well.

Shares of Wal-Mart Stores Inc. (WMT) , with a yield of around 2.4%, are up more than 22% in 2012. Microsoft Corp. (MSFT) , with a yield topping 3%, has gained 14%; Colgate-Palmolive Co. (CL) , yielding 2.4%, is also up about 14%. Some losers in this higher-yield group: McDonald's Corp. (MCD) and Chevron Corp. (CVX)

What to do: Dividend strategies have become enormously popular, and with that, more investors are concerned that the valuations of these stocks are getting stretched. Those worries may be premature, but it's worth remembering former Wall Street analyst Bob Farrell's second rule of market behavior: "Excesses in one direction will lead to an opposite excess in the other direction."

That said, dividend-hunters can take comfort owning shares of companies with a history of dividend growth and not just a current high yield. Companies with strong cash flow and a history of raising dividends year after year will likely continue to attract investment.

"In an era of relatively modest stock market gains," said John Osterweis, a lead manager of Osterweis Fund(OSTFX) "dividends are going to make up a good percentage of total equity returns."

5. Small-cap stocks

U.S. small-caps didn't fare so well in 2011, but performance has perked up so far this year, with the benchmark Russell 2000 Index (RUT) gaining almost 8%.

What to do: Small-caps deserve respect but don't always get it.

Performance this year is close to the 11.5% return that Steven DeSanctis, Merrill Lynch small-cap strategist, has forecasted for the group. And while these stocks are lagging most large-caps, they're outpacing midcaps and trouncing Chinese stocks.

Investors considering small-caps should be mindful that a slow-growth U.S. economy will hurt many of these mostly domestic companies. So the general rule of owning high-quality, cash-rich companies applies here as well.

"Although the Russell 2000 is pushing up against our return target for this year already, we still think that the size segment has some positive attributes," DeSanctis wrote in a report to clients. "Valuations are not stretched and fundamentals remain solid."

6. High-quality European stocks

Investors in Europe have been trying to catch a falling knife. The absence of a solution to the euro-zone debt crisis leaves a continent-wide abscess that has yet to be addressed in firm, decisive ways.

What to do: Don't give up on Europe, but many strategists favor emerging markets in Asia over developing Latin America, Eastern Europe, the Middle East and Africa.

Within developed Europe, intrepid buyers could find that "attractive valuations and depressed prices could lead to short-term rallies in European equities," Merrill Lynch analysts noted, though they added that a sustainable rally is unlikely until Europe's policymakers attack the continent's banking crisis head-on.

For now, pay attention to what Merrill calls Europe's "best of breed" companies. The firm's recent European recommendations mostly focused on U.K.-based stocks including AstraZeneca PLC(AZN) , WPP PLC(WPPGY) and Compass Group PLC(CMPGY) , plus Germany's Siemens AG(SI)

7. U.S. dollar

The U.S. dollar has gained at the expense of the euro, which was the forecast made in January.

The U.S. Dollar Index (DXY) is up 4.3% so far this year, while the euro (EURUSD) currently trades around $1.22 to the U.S. dollar, down from a 52-week high of about $1.45. An exchange-traded proxy for the dollar, PowerShares DB U.S. Dollar Index Bulliish Fund, has gained about 2.5% in 2012.

What to do: "Maintain a core position in the U.S. dollar," said Christopher Vecchio, a currency analyst at DailyFX. He suggested that investors stay bullish on the dollar until the Fed moves to ease monetary policy, which would be perceived as devaluing the dollar and positive for commodities and the currencies of commodity-producing nations.Read more: Strong dollar hurting U.S. companies' bottom-line.

8. Gold

Gold prices have been volatile this year. Exchange-traded proxies SPDR Gold Trust (GLD) and iShares Gold Trust(IAU) are essentially flat. Gold miners have been slugged: Market Vectors Gold Miners ETF (GDX) , a proxy for the group, is down 19% so far in 2012.

What to do: Weak global growth is dragging on gold prices. India and China are among the world's largest gold buyers, and the slowdown in those major economies have taken a toll on precious metals.

Gold may have lost its speculative quality of recent years, but it still protects against global upheaval. "Gold is a valuable part of a portfolio," said Nicholas Colas, ConvergEx Group chief market strategist. "It's the one thing that will work when nothing else does. If policymakers make a dramatic misstep, gold is good insurance. If they get it right, then the other 90% of your portfolio is going to do so good, you won't mind."

9. The presidential cycle

Presidential election years typically are not the strongest in the four-year market cycle; the third year is. But 2011 was unusually weak; and 2012 so far has been unusually strong.

U.S. stocks have gained 5.7% on average in election years since 1944, according to S&P Capital IQ. But the S&P 500 has already topped that, rising more than 7%, including dividends, for the year through July 12.

What to do: U.S. stocks tend to do better in the fourth quarter of an election year, once the votes are counted. Third quarters are generally weak for stocks, and election years have been no exception. That could change this year if the Fed pumps liquidity into the markets after its mid-September meeting.

10. Safety and income

In this uncertain geopolitical environment, alarming headlines are giving investors headaches. Focusing on safety and income at a reasonable price -- the advice in January from David Rosenberg, chief economist & strategist at Toronto-based wealth manager Gluskin Sheff + Associates -- has proved prescient.

What to do: An old Wall Street adage says that when growth is everywhere, the market prices it like water. When growth is scarce, it's priced like diamonds.

Welcome to the Diamond District. Investors have to pay up for growth. Safety and income is also more expensive. But the goal of investors nowadays should be the return of capital, not return on capital.

Moreover, safety can still be had at a reasonable price if you know where to look. At Gluskin Sheff, clients have positions in consumer-related businesses including Home Depot Inc. (HD) , which yields 2.3%, and General Growth Properties Inc. (GGP) , with a 2.2% yield.

"The profit headwinds are fairly acute," Rosenberg said in a recent note to clients. "As such an overall defensive philosophy at the current time is still required."