Cyclical shares have been the place to be for most of 2009. Economically-sensitive industries like mining and general retail have rocketed, leaving many defensive sectors standing. In fact, cyclical shares have reached multi-year highs relative to defensive shares.
Just as betting on cyclicals to beat defensives was the trade of the year in 2009, betting on defensives to make up lost ground could be a winning strategy in 2010. There are a number of reasons - fundamental and technical - why we might expect this to happen.
The recent outperformance of cyclicals over defensives was based partly on hopes of economic recovery. However, there is growing evidence that the pace of the upturn may be slowing. Leading indicators of economic activity are rolling over, raising the spectre of renewed difficulties next year.
Following their breathtaking rally, defensives look undervalued compared to cyclicals. To give one striking example, the dividend yield on the FTSE food retail sector - a key defensive industry - is close to an all-time high compared to that on the FTSE mining sector.
When prices get as far out of kilter as they currently are, they very often snap back strongly. This is exactly what happened in 2007-08, the last time that defensives were low compared to cyclicals. The move went too far, too fast, though.
Of course, there is a substantial risk that the stock market as a whole will do badly in 2010. In such an environment, both defensives and cyclicals might fall in absolute terms. But, as long as defensives fall by less than cyclicals, you can still make good profits.
The strategy to employ is a pairs trade. This works by simply buying the 'low' side of the pair and short-selling the 'high' side of the pair. As the gap between them closes, you make a profit, even if both are falling.
Spread bets are the ideal tools for private investors to do a pairs trade. They cover a wide range of companies' shares, as well as entire sectors of the market. So, you could easily buy, say, the supermarket sector at the same time as short-selling the mining sector. And all profits are entirely free of tax.
As always with spread betting, the safest approach is to enter the trade once the move you're hoping to ride actually begins. Just because one price has got way out of line with another one isn't a reason in itself to trade. After all, the relationship could get even further out of kilter before it snaps back.
To identify pairs trading opportunities and entry points, you simply plot one price against another - see chart, above. In the accompanying chart, food retailers are plotted versus miners. The yellow circles highlight the turning points at which you might try and open short-term positions.
