Sector Valuation Analysis
By Chris Puplava, May 2, 2007
Sector analysis was done by looking at relative twelve month performance of each sector to the S&P 500 (a measure of overbought or oversold) and sector valuations. Twelve month relative performance for each sector relative to the S&P 500 is shown below. Values greater than zero represent twelve month periods of excess returns over the S&P 500 and values less than zero indicate periods of underperformance. The red lines indicate two standard deviations (SDs) above and below the mean (relative average performance since 1990), with values falling within the two redlines approximately 95% of the time (assuming performance is normally distributed). Values near or beyond the solid red lines indicate statistical extremes of value, either undervalued (lower red line) or overvalued (upper red line), where values should fall outside these limits only 5% of the time.
The twelve month relative performance shown was smoothed and serves as a type of momentum gauge in terms of price performance.
Accompanying the twelve month relative performance charts are composite valuations of price-to-book value (P/BV), price-to-sales (P/S), price-to-cash flow (P/CF) and price-to-earnings (P/E) given below showing the average for the deviations from the mean for each individual price multiple. When earnings displayed extreme cases of volatility the composite valuation for that particular sector excluded the P/E multiple and included the other three measures. The sectors with all four price multiples included were health care, consumer staples, and financials, with the other sectors excluding P/E. The top five sectors will be presented based on their 2007 year-to-date (YTD) performance, with the lagging five sectors presented next week.
Table 1. S&P Sector YTD Performance (as of 05.02.07)
The best performing sector so far has been the utility sector with a YTD return of 14.26%. The performance in the sector is likely the result of sector rotation into what is seen as a defensive sector with its high dividend relative to other S&P sectors, and the fact that utilities are interest rate sensitive and benefit from lower interest rates. The sector took off like a rocket at the end of last year when interest rates fell and the sector continued to soar despite interest rates bottoming and turning up. Looking at the sector's twelve month relative performance shows that it has reaccelerated upwards as there is clear momentum behind the sector (Figure 2).
Source: Moody's Economy.com
There is a negative factor that may cap how high and long the sector can continue to perform, which is the sector's rich valuations. The sector is back to valuation levels seen in late 2000, at more than one and a half SDs above its average composite valuation. The sector corrected sharply from late 2000 to 2002 the last time valuations were this high. Part of the reason valuations are at lofty levels is due to the sector's rising from the middle of 2003 to late last year despite a difficult business environment as interest rates were rising. This can be seen in Figure 1 where the sector's stock price diverged from interest rates (inverted in figure) leading to valuation expansion. This is a sector that value investors should stay clear from as there is very little value to be found.
Moving on, the number two performing sector YTD is the material sector with a 10.70% so far this year. Pointing to the fact that this decade's theme has been tangible assets (commodities, land), as opposed to paper assets, the material sector's twelve month relative performance has only briefly spent time in negative territory and has seen peaks in relative performance as high as 35% in excess of the S&P 500. The sector's outperformance has been decelerating slightly, likely the result of lofty valuations (Figure 5).
Investors should be wary of the sector at current valuations which were at two SDs above its composite valuation average. Valuations at these levels have usually marked sharp corrections in the sector when looking at Figure 5 above, where valuations above one SD or greater (red line) saw sharp pullbacks in the sector (black line).
The number three performing sector YTD with an 8.25% return is health care. The sector does very well in a negative economic environment as seen by Figure 6 below, where the sector outperformed in both the 1990 and 2001 recessions, and also the 1994-1995 mid-cycle slowdown. However, the sector has been in the dog house since 2003, underperforming the S&P 500 on a twelve month relative basis since 2003 except for a brief period in 2005.
The underperformance of the sector coupled with its steady earnings stream have compressed valuations to levels not seen in over a decade. There is no other sector within the S&P 500 that is more undervalued than health care, with the sector selling at bargain levels. This may be changing as the sector has broken out recently and was the top performing sector in the April rally as many companies within the sector had blow out earnings that exceeded analyst expectations.
Not only are valuations a compelling reason to invest in health care, but there are many other fundamental factors to be invested in the sector which have been commented on in previous WrapUps (01.17.07 & 03.21.2007), and was one of the macro investing themes covered in the beginning of the year.
Coming in fourth for 2007 YTD performance is energy, up 8.02%. Like materials, commodity related sectors have been the clear winners this decade with none putting in a stronger performance than energy. The sector's twelve month relative performance reached two SDs above its long term average in 2005, indicating a likely period of decelerating outperformance, which was seen from early 2005 to the present. The sector's relative performance has reaccelerated lately and may be set to continue. Its relative performance is sitting on its trendline that began in 1998 when oil was under $15 a barrel, with the next low in 2003 that marked the beginning of the bull market in energy. With the sector's current position touching its trendline, this may be a possible point marking the next acceleration in energy's outperformance of the market.
The sector's valuations reached one SD below its composite average in the middle of last year, at a level that marked the beginning of the energy bull market in 2003. Current valuations are neutral, indicating still more room in the sector for price appreciation resulting from valuation expansion, though with rising energy prices lately the sector's revenue stream is likely to increase in the near future which may keep valuations at neutral levels. There are many factors supporting the case for the outperformance of the energy sector to continue, possibly out to the end of the decade. These factors were touched upon in one of the macro investment themes touched upon in the beginning of the year (Betting On Oil: Opportunity of the Decade?)
Coming in fifth for YTD performance, and first place for 2006 performance is the telecommunication service sector, up 7.90% YTD. The sector, like health care, has been in the dog house for most of the decade with brief periods of outperformance. Last year marked a breakout year for the sector which posted the greatest performance of the ten S&P 500 sectors, up roughly 27%.
There is more room for the sector to continue to outperform the broad market as valuations are still at compelling levels, just under one SD below its composite average over the last decade, with 2006 probably marking a kickoff to the sector's long-term outperformance. Next, the five lagging sectors in terms of YTD performance will be covered.
TODAY'S MARKET - Economic Reports
MBA Mortgage Applications Survey � Week of 04/27/07
Mortgage demand rose 0.6% last week led by a 4.0% increase in purchase applications and a 3.2% decline in refinance applications. The contract rate on the 30-year FRM increased 1 basis point to 6.14% while the 1-year ARM rose 1 basis point to 5.79%.
Source: Moody's Economy.com
Oil & Gas Inventories � Week of 04/27/07
Crude oil inventories rose 1.1 million barrels last week, in line with expectations of a 1.0 million barrel increase. Gasoline inventories continued their slide for the twelfth straight week, falling 1.1 million barrels, also in line with expectations calling for a 1.0 million barrel decline. This puts gasoline inventories well below the average range for this time of year (see figure below). Distillate inventories were relatively unchanged, falling 0.2 million barrels while expectations were for a 0.4 million barrel build. Both gasoline and crude oil inventories are below last year's levels, with gasoline inventories down the greatest (-7.0%) followed by crude (-3.3%).
Source: Energy Information Agency (EIA)
Source: Moody's Economy.com
Source: EIA, This Week In Petroleum
Factory Orders � March
Factory orders rose a strong 3.1% in March, coming on the back of a 1.4% rise in February. Inventories rose 0.2% while shipments rose 1.5%, leading to a decrease in the inventory-to-shipments (I/S) ratio to 1.23 from February's 1.25, though still at elevated levels.
Source: Moody's Economy.com
The Dow Jones Industrial Average reached another record, breaking the 13,200 mark for the first time, and the S&P 500 was one point from breaking the 1,500 mark near the end of the day before retreating slightly. Factory orders for March came in better than expected and above February's levels, sending the markets higher as the numbers were taken as signs of a stable economy. The positive news from factory orders propelled the Dow to nearly a triple-digit gain on the day, up 75.74 to close at 13211.88 (+0.58%). The NASDAQ was up 26.31 points to close at 2557.84 (+1.04%) and the S&P 500 was up as well, rising 9.62 points to close at 1495.92 (+0.65%).
Investors sold Treasuries today with the 10-year note yield at 4.646%, rising 0.4 basis points. The dollar index was up on the day, rising 0.04 points to close at 81.76. Advancing issues represented 72% and 67% for the NYSE and NASDAQ respectively, with up volume representing 82% and 81% of total volume on the NYSE and NASDAQ, reflecting a mixed trading day in the markets.
Energy prices were mostly down on the day after release of petroleum inventories, with most energy products coming in line with expectations. Precious metals were mixed on the day with gold falling $0.75/oz to $672.70/oz (-0.11%) and silver down $0.05/oz to close at $13.20/oz (-0.38%). Base metals were mostly up with zinc up the most (+1.59%), while aluminum displayed the weakest performance (-0.07%).
Overseas markets were up with the a big move seen in the Chinese Shanghai Index (+2.17%) and a strong showing in Canada's TSX Index (+1.29%). Taiwan's Taiex index displayed the greatest weakness, up 0.35%.
The move in the markets was broad based as all ten of the S&P 500 sectors were up on the day, with materials (+1.16%), telecommunications (+1.10%) and consumer discretionary (+0.93%) putting in the strongest advances. The greatest weakness was seen in consumer staples (+0.17%) and health care sectors (+0.47%).
© 2007 Chris Puplava