'Dash for trash' among mid-caps shows no sign of losing pace

After two years of pain, mid-caps are in the ascendancy once more. Since the start of the year the FTSE 250 has outperformed the FTSE 100 by 23 per cent as investors have sold defensive sectors, such as pharmaceuticals and tobacco, and piled into cyclical stocks such as retailers, housebuilders and pub operators.

So fierce has been the rotation, which has seen the share prices of companies such as Taylor Wimpey and Punch Taverns more than double in the past month, that market watchers have rather unkindly dubbed it the "dash for trash". But how much longer can this outperformance, which has characterised the recent recovery of the UK market, continue? And should investors be looking to make the switch back into defensive stocks that offer much safer dividend yields?

There are several catalysts for the re-rating of cyclical stocks, which make up a fifth of the FTSE 250, against just 6 per cent of the FTSE 100. The most important is the view held by many investors that the rate of decline in key economic data is slowing and therefore the markets may have bottomed.

They also see domestic companies as benefiting more from the efforts of the government and the Bank of England to stimulate the UK economy. Indeed, the improvement in household cashflow brought about by lower interest rates and a lower oil price, is one of the reasons why many of the big investment banks are positive on consumer cyclicals. It may also explain why sales at companies such as Marks and Spencer have held up better than many had expected.

On top of that, a clutch of cyclical companies with high debt levels have been able to refinance, either by striking new deals with their lenders or raising fresh equity. These companies were heavily sold off last year on the assumption that shareholders would see their investments wiped out by debt-for-equity swaps. But with companies such as Taylor Wimpey reaching agreements with key creditors, short sellers have been forced to buy back their positions, which has helped push prices higher. The result is that the FTSE 250, which has lagged behind the FTSE 100 since April 2007 (but outperformed through the four-year bull market that started in 2003), has gained 15 per cent this year. By contrast, the FTSE 100 is down 7.7 per cent.

The flip-side of the cyclical re-rating has been selling of defensive stocks which, along with financials, make up 40 per cent of the FTSE 100. Tobacco and pharmaceuticals stocks, for example, have underperformed by around 10 per cent since the start of the year.

"Many defensive stocks are now trading at a significant valuation discount to the wider market, while offering some of the more secure dividends," according to Cazenove's Darren Winder. He says the prospective price/earnings ratio of a basket of 10 of the more defensive FTSE 100 stocks (including AstraZeneca, British American Tobacco and Diageo) is trading at a level last seen during the tech boom of the late 1990s. This seems perverse given that we are in the middle of what could be the biggest recession since second world war.

Traders believe the cyclical rally will be tested in the coming weeks by the US earnings season and the release of key economic data in the UK. Next week, for example, brings the budget and key readings on inflation, unemployment, retail sales and GDP. These will help to establish whether the rate of deterioration in the economy is slowing.

There are other challenges ahead. Traders are bracing themselves for a fresh wave of rights issues as companies look to take advantage of the recent market rally to raise fresh equity. Indeed, Citigroup expects €200bn ($260bn) to be raised across Europe over the next 18 months.

Some investors are already locking in gains. Philips yesterday sold its 17 per cent stake in Pace after the share price of the set-top box maker almost doubled in a month.

All of which could put the brakes on the recent rally. But if the economic data does not get any worse and banks on both sides of the Atlantic continue to report strong trading, there is no reason to think the "dash for trash" will end. And as long as the cyclical rally continues the FTSE 100 will lag behind its younger rival.

neil.hume@ft.com