Cyclical stocks are likely to lead the market higher in 2017, says Rob Taylor, senior vice-president and portfolio manager at Canoe Financial LP. He predicts that the key to outperformance will be stock picking and sector rotation from higher-yielding defensive stocks to more cyclical fare.
Taylor, lead manager of Canoe Equity Class, sees 2016 as a transition year, following a tough couple of years of plummeting oil prices and a significant market downturn. "We feel that we are in the middle of a recovery," says Taylor, "likely in the fourth or fifth inning of the market move."
Anticipating a recovery, the stock market has started to move higher even though we haven't necessarily seen the global economy improve to any significant degree as yet, Taylor adds.
During the downturn, the market's investment flows were piling into a limited number of defensive, high-yielding stocks and the valuations got really extended, says Taylor. Some of those areas included real estate investment trusts, power utilities and telecommunications companies, all of which are in interest-sensitive sectors that traditionally do very well as rates are declining.
As interest rates start to move higher and economic growth starts to improve, says Taylor, money will shift away from the interest-sensitive sectors. It will head into cyclical sectors such as energy, industrials, technology and financial services.
As a contrarian investor with "a value tilt and an out-of-favour" approach, the Calgary-based Canoe team was already thinking in 2015 about this sector rotation in market leadership. The Nov. 8 election of Donald Trump as the next U.S. president hasn't altered their investment strategy, Taylor says.
The team remains bullish on the energy sector. For example, Storm Resources Ltd. (SRX), an oil and gas company based in Alberta, is among the top holdings. "It's an energy stock that's been a long-term holding of ours," says Taylor. "It's a very high- quality asset, with a great management team and a good runway for growth." The team thinks it's very attractively valued and that a re-rating of the stock is likely to happen in the next 12 to 18 months. "So it's a combination of a good-quality core holding with growth potential."
Since the Canadian stock market is highly concentrated in financials and resources stocks, the Canoe team looks outside Canada to diversify and to boost returns. U.S. equities currently represent 42% of the portfolio of Canoe Equity, which is in the Canadian Focused Equity category.
For example, U.S.-based technology giant 
Microsoft Corp. (MSFT) is among the top holdings. "If you think back to Microsoft two to three years ago," says Taylor, "it was a very cheap, high-quality stock, with a good earnings profile and a dividend yield." There's been a re-rating of the stock since then and now there's about 10% earnings growth and a 2% to 3% dividend yield. "It's a high-quality franchise that we think offers consistent growth for a long period of time."
The Canoe team also favours U.S. financial stocks, of which three -- including U.S. Bancorp (USB) -- are among the fund's top holdings. "Obviously there's been a significant move in the U.S. financials," says Taylor. "We were really feeling like they were very undervalued. They were one of the worst performing sectors this year. We believe if this cyclical leadership continues to take hold in 2017, we'll continue to see rates likely move higher and that will help the U.S. financials continue to perform."
Union Pacific Corp. (UNP), also among the top 10 holdings, is another example of a U.S. cyclical play. The major railroad company has seen significant downward revisions in earnings, as a result of the global slowdown over the last couple of years. "We feel that the company has troughed," says Taylor, "and we should see some earnings revisions higher over the next year or two."
Today, the consumer area may offer out-of-favour opportunities. "So you think of where the leadership was last year," says Taylor, "in things like Nike Inc. (NKE) and Starbucks Corp. (SBUX). Nike is down 30% plus and Starbuck's down probably 25%. A lot of those stocks in the consumer-staples area have seen significant corrections."
But Taylor thinks it's a bit too soon to buy some of the depressed consumer stocks. He feels there's still more runway for the cyclical leadership positions to continue, at least for the first couple of quarters in 2017. "Then I think we'll be starting to think about where do we rotate into next, and it might be in some of those consumer areas."
Looking ahead farther down the line, over the next five years or so, Taylor thinks we could continue to be in a lower-return type of market environment. "Having the ability to pick stocks and make these rotations from an outperforming sector to an underperforming sector to add value, is going to be really important."
