Don't Buy Stocks in These Market Sectors in 2012

For most of last year, investors spent their time contemplating another recession in the U.S. and what impact the European debt crisis would have on U.S. stocks. This year, optimism abounds that the U.S. won't head into a recession despite the dangers that lurk in Europe.

Still, that doesn't mean every stock and sector will perform well in 2012. Even though Wall Street watchers are taking a more positive stance, investors should be wary of some areas.

"Overall, I'm bullish on the markets," says Kevin Cook, senior strategist at Zacks Investment Research, a Chicago investment research firm. "But you have to be a stock picker. There are sectors to be cautious about."

According to Jon Ten Haagen, founder and principal of the Huntington, N.Y., investment advisory firm Ten Haagen Financial Group, 2012 could be the year when stocks that got pummeled come into favor while good performers take a hit. Take utility stocks as one example. The sector enjoyed a significant surge in 2011 as investors turned to it as a safe haven. But Ten Haagen and other financial advisers say that same group could lag other sectors in 2012.

"The stock market is cyclical. If one gains a lot, it also has a lot to lose," says Gary Harloff, founder of Westlake, Ohio-based Harloff Capital Management.

Meanwhile, Larry Swedroe, director of research for the BAM Advisor Services in St. Louis, advocates diversifying large, growth stocks (blue chips or established companies with a large market capitalization) with small, value stocks (companies with a small market capitalization and low or depressed stock prices), arguing investors will enjoy better-than-expected returns from those small, cheap stocks. Sure, these types of stocks are much riskier, but according to Swedroe, you'll get a bigger return if what's expected happens.

Big banks a bad bet in 2012

What stocks and/or sectors should investors stay away from this year?

According to some money managers, one industry that screams "avoid" is big banks. Large national banks dealt with a lot of problems last year, from bad mortgage lending to exposure to Europe as well as a decline in revenue from the investment banking and proprietary trading businesses. Cook says that this year, they will still be on the hook for all that was bad in 2011.

The major banks that grew through merger deals over the past three years are going to underperform, Cook says. Sure, the stocks appear cheap after their share prices plummeted in 2011, but Cook advises buyers to beware.

If you do want to own bank stocks, he suggests regional banks that have no exposure to Europe, investment banking and proprietary trading.

Utilities, Materials Stocks Could Underperform

Not only did utilities enjoy strong growth in 2011 that could slow down or reverse this year, the sector is also facing a political environment that may hurt growth. Congress is "taxing everything and anything and will possibly start looking there," says Ten Haagen. What's more, the utility sector could face more regulations as people demand cleaner energy, he says. Not to mention growing concerns over the safety of nuclear energy.

Another area that is expected to underperform this year is the materials sector, or companies that dig stuff out of the ground such as iron ore and copper, according to Cook. Even though many analysts expect the price of oil to rise, there seems to be enough supply, he says. What really will weigh on the stock prices of materials companies is a slowdown of economies outside the U.S., he says.

"A year ago, the global economy looked great. The U.S. was growing, Europe seemed to be doing OK and China was trying to slow things down," Cook says. "Now China is at risk of slower growth, and Europe is headed into a recession. Now's not the time to be buying copper or iron stocks."

Aerospace and Defense Budgets Get Sliced

Budget cutting by the government will play a major role in the decline of some stocks in 2012. According to Harloff, the U.S. government's defense budget is slated to be cut by around $45 billion per year over the next decade, which won't bode well for aerospace and defense companies.

"There's less bombs, less boots on the ground, less tanks and (less) military airplanes," says Harloff, noting that the earnings of aerospace and defense companies will likely decline with the slowdown in government orders.

Diversify for Better Returns

Whether you're looking to avoid certain stocks or buy different ones, experts say the best way to play the stock market is to diversify and rebalance your portfolio as needed. While you shouldn't put a time frame on when you rebalance, Ten Haagen says a good rule of thumb is to do it when the portfolio has grown or lost ground by 3% to 5%.

Take Swedroe's idea of diversifying large, growth companies with small, value stocks. He says you should be diversified across asset classes instead of putting all your money in one or another. But that doesn't mean you buy and hold the stocks for the long haul. You'll need to rebalance the concentration of stocks, depending on how the companies in the portfolio are performing.

Ten Haagen says that when a portion of your portfolio is doing well, take the profits and reposition them in a part of the portfolio that hasn't been performing well. "You can't guess which industry is going to be good at all times," Ten Haagen says. "You have to diversify yourself across the board. It forces you to sell high and buy low."