Sector Valuation Analysis Part II -- 2007 YTD Laggards
(Special Note on Energy near bottom)
By Chris Puplava, May 9, 2007
Last week I covered the top five performing S&P sectors in terms of year-to-date (YTD) performance, as of May 2nd. Presented this week are the laggards, and for an explanation of the charts listed below and their construction please see the opening paragraphs to last week's WrapUp (05/02/07).
Coming in sixth place for YTD performance behind the telecommunications sector is the industrial sector, up 6.45% YTD. The sector has outperformed the S&P 500 for most of the current decade with a few periods of underperformance, which the sector is currently displaying.
The out-performance of the sector for most of the decade has propelled it past its 2001 highs, a feat the sector accomplished last year, with room for further upward mobility as its valuations are currently neutral. The deviation from its composite valuation is just barely visibly above zero, indicating that the sector's run from 2003 has been predominantly earnings driven as opposed to multiple expansion.
Trailing the industrial sector so far this year is the information technology sector, with a YTD performance of 5.25%. The relative performance for the technology sector is almost the mirror image of the industrial sector, as it has underperformed for most of the decade with a brief period of out-performance of the S&P 500 in 2003.
The sector underwent a severe period of underperformance which reached a zenith of -35% in late 2000 into 2001. The strong underperformance compressed the sector's composite valuation from almost four standard deviations (SD) from its average value in 2000 to one SD below neutrality in 2002. The sector's current valuations are roughly 0.5 SD below average valuation, with the sector's price closely following its valuation trend. The relatively low valuations within the group leaves room for multiple expansion that may propel the sector further. A special note needs to be made in terms of the composite valuation shown below. The irrational exuberance displayed in the sector back in 2000 led to multiple expansion behind any means of reason to four SD above the average valuation. This extreme move in valuations leads to an upward bias for the calculation for average valuation for the composite, and so the valuation composite below should be viewed with this in mind, indicating that the valuation for the sector is more richly valued than what may appear below.
Coming in eighth place is the consumer staples sector, with YTD performance of 4.83%. The sector performs well during periods of economic weakness, as seen in its relative performance in the 1990 and 2001 recessions. The upwards trend in relative performance is hinting that the sector is likely headed towards a period of out-performance of the broad market, which makes sense as the economy has clearly slowed with Q1 GDP coming in at 1.3% after falling from the 5.6% pace seen in Q1 2006. For further support of the sector's likely out-performance please see commentary from a pervious Observation (03/21/07).
Like the industrial and health care sectors, the price advance in the sector has been entirely earnings driven and not by multiple expansion as the sector's valuations have been compressed to one SD below its composite valuation, valuations that have marked the starting point of strong price advances seen in 2000 and 2003. Despite the sector breaking out last year and surpassing its 1999 and 2002 highs, the sector still remains undervalued and is an excellent area for value investors, likely benefiting from sector rotation as the economy slows and consumer spending on non-discretionary items gains in relative strength to discretionary items.
Coming in ninth place, not surprisingly, is the consumer discretionary sector with a YTD performance of 2.74%. The sector is finally starting to feel the pinch from the string of rate hikes by the Fed and a housing recession that has removed a significant support to consumer spending through cash-out refinancing and mortgage equity extraction. On a twelve month basis the sector is outperforming the S&P 500, though this period of out-performance appears to be ending at the twelve month relative performance for the sector appears to be rolling over. The consumer discretionary sector typically moves in opposite direction to the consumer staples sector, which was the case back in the 1990 and 2001 recessions where the sector underperformed the S&P 500 with the consumer discretionary sector outperformed. The consumer discretionary sector's twelve month relative performance is rolling over at the same time the consumer staple�s sector is turning up, with both movements hinting at economic weakness further ahead as stocks are seen as discounting future developments.
The surge in the sector's price last year came off last summer's lows in the markets and was driven not by fundamentals, but by multiple expansion with the sector's composite valuation moving from 0.5 SD below the average to 0.5 SD above the average. With the economy slowing, neutral to slightly overvalued valuations, and a twelve month relative performance that appears to be rolling over, investors should be wary about investing in the sector in the months ahead, as it appears the sector already priced in a soft landing last year as seen by its multiple expansion. Any developments that negate the soft landing thesis will likely bode poorly, and if a soft landing does occur, much of this event has already been discounted with the sector not far from one SD above average valuation. At either rate, don't expect positive fireworks from the sector, if any being short lived.
Coming in dead last is the financial sector with a YTD performance of 1.00%. This comes as no surprise as the sector is also feeling the pinch from the string of Fed rate hikes that cut into the sector's profit margins. The sector has been a star performer this decade with only a small period of underperformance seen in early 2005. However, the sector's out-performance on a twelve month basis has been decelerating and looks likely to cross into negative territory (underperformance) shortly after rolling over in early 2006.
Look for the financial sector to turn around with a sharp advancement in price when the Fed does bring relief in terms of rate cuts. The sector's price advance from 2005 through the current has been on the backs of strong profit growth and not multiple expansion as the sector is a clear benefactor from riding the liquidity wave. With valuations near one SD below average valuation and twelve month relative performance near neutral, this sector may explode upwards when Fed relief becomes more of a reality than wishful thinking.
In summary, the sectors that provide the greatest investment in terms of valuation are health care, consumer staples, financials, and telecommunication sectors, with health care and consumer staples presenting the strongest fundamental case outside of valuations. Sectors to avoid would be the utility and materials sectors, as their valuations are 1.5-2 SDs above average valuations, indicating investors should not chase this year's top two outperforming sectors on a risk to reward basis.
TODAY'S MARKET - Economic Reports
MBA Mortgage Applications Survey - Week of 05/04/07
Mortgage demand rose 3.6% last week led by a 4.9% increase in refinance applications and a 2.6% increase in purchase applications. The contract rate on the 30-year FRM decreased 4 basis points to 6.10% while the 1-year ARM fell 8 basis point to 5.71%.
Source: Moody's Economy.com
Oil & Gas Inventories - Week of 05/04/07
Crude oil inventories rose 5.6 million barrels last week, well above expectations of a 0.4 million barrel increase. Gasoline inventories rose for the first time in over three months after sliding for twelve straight weeks, rising 0.4 million barrels, also in line with expectations calling for a 0.3 million barrel rise. Gasoline inventories are still well below the average range for this time of year (see figure below). Both gasoline and crude oil inventories are below last year's levels, with gasoline inventories down the greatest (-7.0%) followed by crude (-1.7%).
Source: Energy Information Agency (EIA)
Source: EIA, This Week In Petroleum
One thing I would like to point out is the surge in refining margins (3-2-1 Crack Spread), up 245% year-to-date, has led to a strong compression in the price multiple of crude oil (WTIC) to the crack spread from 14.31 in September of last year down to 2.4 presently. Back in September the multiple was 4.5 standard deviations above its average for the last ten years, a huge statistical extreme.
The question back in September was, 'Is the extreme multiple due to crude oil being over priced relative to refining margins or refining margins severely under priced relative to crude oil?' The markets answered this question as refining margins surged 245% this year alone, driving the multiple down to nearly two standard deviations below the mean, a 6.5 standard deviation price swing! Also note the huge spread seen in the second chart below ("Crude & the Crack Spread").
It's no wonder that the refiners have been some of the strongest performers in the energy sector this year. The Energy Information Agency (EIA) points out that this may soon change as high gasoline prices in the U.S. are encouraging greater domestic production, rising gasoline imports, and decelerating gasoline demand, all of which translate into lower gasoline prices ahead, though maybe only temporarily as the summer driving season is upon us.
The Dow Jones Industrial Average reached another record as it approaches the 13,400 mark, and the S&P 500 is closing in on its all-time high reached in 2000. The markets were relatively flat until the FOMC announcement to leave rates steady at 5.25%. The markets initially spiked lower before reversing course and spiking back up to finish up on the day with the Dow finishing up 53.80 points to close at 13362.87 (+0.40%). The NASDAQ was up 4.59 points to close at 2576.34 (+0.18%) and the S&P 500 was up as well, rising 4.86 points to close at 1512.58 (+0.32%).
Investors sold Treasuries today with the 10-year note yield at 4.668%, rising 3.4 basis points. The dollar index was up on the day, rising 0.09 points to close at 82.03. Advancing issues represented 60% and 53% for the NYSE and NASDAQ respectively, with up volume representing 67% and 57% of total volume on the NYSE and NASDAQ, reflecting a mixed trading day in the markets.
Energy prices were mixed on the day after the release of petroleum inventories. WTIC slipped $0.71 a barrel (-1.14%) with Henry Hub spot natural gas down 2.47%, and spot uranium prices reached a new high at $120 per pound (+6.19%). Precious metals were down on the day with gold falling $5.10/oz to $680.55/oz (-0.74%) and silver down $0.12/oz to close at $13.39/oz (-0.89%). Base metals were up with aluminum leading the pack, up 1.18% while lead displayed the weakest performance, up 0.20%.
Overseas markets were mostly up with a big move seen in the Brazilian Bovespa Index (+2.03%) followed closely by the Chinese Shanghai Index (+1.60%). Taiwan's Taiex Index and Canada's TSX Index displayed the greatest weakness, down 0.53% and 0.15% respectively.
The move in the markets was broad based as all ten of the S&P 500 sectors were up on the day, with telecommunications (+0.69%), industrials (+0.62%) and financials (+0.61%) putting in the strongest advances. The greatest weakness was seen in health care (+0.04%) and technology sectors (+0.05%).
© 2007 Chris Puplava