Think of the economic cycle as a wheel…

This image roughly captures the whole cycle, highlighting the various stages of economic growth and contraction. Right now, we’re just past “9 o’clock” on the wheel, as commodity prices have been steadily rising (although with some recent profit-taking). We’re surely done with the “8 o’clock” phase, where we saw stocks post a remarkable two-year rally after a sudden plunge. If the current cycle plays out as it has in the past, then more stock gains lie ahead, but perhaps in a more limited fashion than some realize. We may be looking at an extended period of economic expansion in coming years, but stocks prices always look ahead and have already anticipated some of that expansion. [For more on how sector rotation can lead you to the right stocks to profit, go here.]

The economy has started to sputter back to life, as seen by rising employment figures and positive quarterly gross domestic product (GDP) reports. We’re just about at “9 o’clock,” or “general recovery.” When monthly employment trends really start to pick up later this year, we’ll move up to “10 o’clock” — “a strong recovery.” Again, some of the recent market rebound anticipates the move into this phase, so by the time we actually enter into the strong recovery phase of the economy, investors will start focusing in “11 o ‘clock.” And though it may seem premature, we’re already looking at the latter stages of a bull market, known as “late-cycle plays.” Increasingly, you need exposure to late-cycle plays to stay one step ahead of the market. The challenge for investors is to have faith that these late-cycle plays will move into vogue, even as they are being shunned right now.

So what are late-cycle plays? Think about anything that only receives real interest once consumers are really confident and broader economic growth is on sound footing. We most recently saw such a phase from 2005 to 2007, when homes were selling in high numbers, car sales hit new peaks and small businesses were confident to heavily invest in growth initiatives. It takes a leap of faith to imagine we’ll get there, and it could be a good 18-24 months before the animal spirits are truly in evidence. But the stocks that benefit from such an environment, the “late-cycle plays,” will surely rise well in advance, if history is any guide.

There are three late-cycle groups I have in focus…
1. Consumer-focused stocks are a clear beneficiary. At some point, perhaps in 2012, retail sales are likely to steadily build higher as rising employment levels lead to heavier consumer spending. And as I noted last year, retailers are in such strong shape that simply moderate sales growth could trigger faster profit growth.

My favorite retailers right now include:

• Aeropostale (NYSE: ARO), which is very inexpensively valued, is buying back lots of stock and is always just a few quarters away from the next hot trend.
• Radio Shack (NYSE: RSH), which is currently in transition as new management comes in, but still possesses robust cash flow characteristics. [Read more of my analysis here]
• Kohl’s (NYSE: KSS), which makes the right moves year after year and is blessed with very reasonable valuations. [Read more here] 

2. I also think you need to keep watching the home-building stocks. Conditions remain tough, and any real upturn is at least a year or two away. But investors will rotate back into this sector long before it is fully healthy. [I noted three home builders that look poised for a good recovery in this article.]

3. Lastly, the major bank stocks are likely to fare very well in this phase of the economic cycle, benefiting from higher lending activity and expanded profit spreads on their loans. That’s why Warren Buffett loaded up on Wells Fargo (NYSE: WC) in recent months — he’s got a multi-year view on how the bank will fare in an improving economy.

Action to Take –> If there is a downside to this investing theme, it’s that the stock market will likely have peaked once these un-loved sectors move back into vogue. Even if the economy ends up booming a few years from now, rising interest rates and fears of eventual fatigue in the economic expansion will cause many institutional investors to rotate away from stocks and into safe plays such as fixed income. But for now, get ready to gear up these late-cycle plays.

P.S. — I don’t know if you’re aware of this or not, but a 20-year energy agreement between the United States and Russia is about to expire. The problem is, this deal supplies 10% of America’s electricity. When the Russians refuse to renew the agreement, the U.S. will face an entirely new kind of energy crisis. This disruption could send a handful of energy stocks through the roof. Keep reading…