A Wall Street chief strategist thinks investors are acting like a recession is already here - and explains why you should buy stocks unfairly neglected by worried traders

• Jim Paulsen, the chief investment strategist at Leuthold Group, says investors are treating companies that are closely connected to the economic cycle - like banks and retailers - as if the US economy is already in the depths of a recession.
• Paulsen says the stocks currently make up an unusually small piece of the stock market by value, showing investors are fearful of a downturn. He thinks this is a major opportunity.
• Since a recession is depressing the value of the stocks already, Paulsen says the group could do very well irrespective of how the economy performs.
• Paulsen says a similar scenario played out during the tech bubble.
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There's a lot of debate in the investing world about whether a recession will arrive soon. But Jim Paulsen, chief investment strategist for Leuthold Group, says the debaters are missing the point.

Paulsen says that when it comes to cyclical stocks - or the companies whose results are most tightly linked to the performance of the economy - investors are acting as if the US were already in the depths of a recession. Ordinarily, the stocks do best when the economy is growing at a quick clip and struggle when it hits a downturn.

Since the stocks are out of fashion now, during a period when the economy is still grinding out growth, Paulsen says they are in position to rally when a full-fledged downturn materializes.

"Most of the time when cyclicality has fallen as fast and as far as it has since last year, the economy has been in or near a recession, and the stock market has been close to bottoming," Paulsen wrote in a note to clients.

The S&P 500 index has a market cap of almost $27 trillion, and Paulsen writes that today, only 34% of that total comes from the four cyclical sectors - consumer discretionary, materials, industrials, and financials. That reflects investors' preference for companies that aren't as tightly linked to the economic cycle such as tech companies, or more defensive sectors like utilities.

Investors appear reluctant to bet that the US economy will keep growing for much longer since it has already been expanding for more than 10 years in one of its longest stretches of growth in its history.

Value in scarcity

Paulsen says that view gives cyclical stocks scarcity value. That means they have a limited supply, little apparent downside, and the potential for real upside.

"Should any evidence of economic revival emerge, the combination of cyclical scarcity and widespread underownership of cyclicality could produce a period of significant leadership by cyclical stocks," Paulsen said.

The stocks haven't done badly this year, since almost every sector of the stock market is up in 2019. But since they're underperforming, Paulsen says the sector has shrunk relative to the rest of the market. The 34% figure is one of the smallest of the past 30 years, and is more typical of its size during a recession.

"Cyclical stocks have become so scarce relative to the overall stock market that the current "recovery debate" might not be that material," he said. "Whether the U.S. soon has a recession or not, the prices of most cyclical stocks have already been adjusted for an economic contraction (at least on a relative basis)."

Investors can gain broad exposure to the four cyclical sectors through funds like the Consumer Discretionary Select Sector SPDR Fund, the iShares US Financials ETF, the Vanguard Industrials Index Fund, and the Invesco S&P 500 Equal Weight Materials ETF. It's also possible to invest in individual sectors within those groups. Examples include the SPDR S&P Bank ETF or SPDR S&P Metals and Mining ETF.

Paulsen says cyclicals tend to bounce back from periods like this in a major way regardless of how the economy performs.

For example, he notes that the sector was pushed to the sidelines during the 1990s tech bubble as investors clamored for tech stocks and little else. And one result that was that cyclicals, which are supposed to be tightly linked to the health of the economy, outperformed the market for several years starting in 2000 in spite of the 2001 recession.

That means the stocks could prosper even if there is a recession in the near future, although they would perform better if economic growth surges again. And the Federal Reserve is in the middle of an effort to keep the economic recovery going, which would aid the stocks.

"Today's extreme scarcity of cyclicality in the stock market suggests investors may be ignoring a potential opportunity to add a rare, unloved asset that has the full support of economic policy officials," he wrote.