Should you leap on a cycle or is it more defensive bull?

For most of 2012 defensive stocks that pay their shareholders generous incomes have been surging higher. In comparison, a range of cyclical companies such as miners, non-bank financials and retailers have become friendless. Up until now equity players have shown no compunction about jumping on the cyclical train, preferring to hide in the likes of Telstra, CSL and Woolworths.

Last week, though, the switch to more risk was pronounced and some follow-through indicated the emergence of a major trend.

Last week's slightly disappointing earnings result by defensive bellwether Telstra may prove the turning point. After years of underperformance, Telstra's share price sprang to life in late 2011 and has notched up gains of almost 20 per cent this year. In comparison, the All Ordinaries Index has only scratched out a gain of 5 per cent. In the past week, though, Telstra's share price has lost about 5 per cent despite the promise of a 14? fully franked dividend in the coming weeks.

Trading in other defensive stocks such as healthcare plays CSL and Ramsay Healthcare and gaming outfits Tatts Group and Tabcorp has also come off the boil despite the market trending higher. During the same period the big mining companies have perked up, with Rio Tinto, BHP Billiton and Woodside leading the charge. Joining in have been cyclical industrials such as Lend Lease and Computershare.

While it is too early to call this a sustainable trend, investors should keep a close eye on proceedings and be overjoyed if it continues.

The genesis of any bull market typically involves a surge in cyclical stocks that will benefit most from an uptick in the general economy. Investors will generally fund their move into cyclical companies by selling out of defensive stocks that have proven winners during the bear market.

Given the troubles in the global economy, what has been the catalyst for the events of last week? A plethora of reasons could be given but I think we should stick with three critical ones.

First, US bond yields have started to jump higher. The 10-year bond yield has firmed from 1.4 per cent a few weeks back to 1.7 per cent. This primarily reflects investor willingness to take on more risk. The bears will argue that the increased appetite for risk has a direct correlation with a high expectation that the US Federal Reserve will soon announce a third round of quantitative easing in a bid to jump-start their economy. This may well be the case, but printing money normally has the affect of pushing yields down further and not up.

A more plausible scenario is that investors are becoming more optimistic about the economic climate. The much watched Citi expectations index of leading indicators has recently turned positive after falling for several months. This tells us the economic numbers being printed in the world's largest economy are starting to match or even beat depressed expectations.

The second reason is that defensive investments have become a crowded trade. In Australia, where the government and corporate bond market is thin, investors have piled into high-yielding stocks that pay fully franked dividends. Eventually a crowded trade results in expensive valuations and leaves fewer buyers to push these stocks higher.

Finally, interest rates in Australia have gradually been coming down. Unlike in Europe, the domestic economy seems to be experiencing a more traditional cyclical economic slowdown. This fundamentally means that low interest rates should eventually start to stimulate economic activity in areas such as housing, transport, retail and financial services. Any meaningful uptick, though, will not become apparent for some time although professional investors will not wait until it actually comes, otherwise they will miss the boat.

As the world's greatest ice hockey player, Wayne Gretzky, (pictured) said: "I skate to where the puck is going, not where it has been."

The confirmation of a trend towards more cyclical stocks should either be confirmed or killed off in the coming weeks. The biggest risk is that the US economy falls in a hole as investors, consumers and business people become increasingly concerned about the looming "fiscal cliff". This involves a reduction in government spending and a hike in a range of taxes that could cut economic growth by as much as 4 per cent in 2013. The US will be at the brink of this fiscal cliff in January and, given the timing of the presidential election in November, may not have been fenced off to the satisfaction of investors.

If US investors do get twitchy about the economic outlook, then you can expect a sharp reversal of last week's trend, with bond yields falling and defensive stocks back in vogue. This would be a conclusive sign the secular bear market is not over and to remain cautious. It is a critical time in markets and is compulsory viewing.

Matthewjkidman@gmail.com