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Sector Analysis - July 1, 2011
Investors who want to look at the "big picture" often start by examining the state of economy and the stock market in general, and then look, in order, at market sectors, at industries within a sector, and then at companies within a given industry.
This week, Value Line provides its quarterly update on the 10 stock sectors we follow, which include nearly 100 industries, highlighting the notable changes that have occurred in the past few months. The sector ranks are based on the Timeliness ranks of the individual stocks within the sectors, and are positioned from 1 (Highest) to 10 (Lowest) in order of attractiveness. We also review sector valuations against their historical ranges and take a look at three to five year total return potential for the ten groups in this report.
Shifts toward safety, big and small, punctuate this week's sector report, although not at the very top, where the Basic Materials group continues to reign. Constituents of that normally cyclical collection of industries have a couple of things going for them they did not in years past. Chemicals manufacturers, for one, are enjoying a revival of business conditions as abundant North American natural gas reserves lower input costs. The Paper & Forest Products industry is being supported by a round of merger activity on the paper and packaging end of business. And Precious Metals companies are still enjoying high price realizations for their ore. Curiously, gold is these days being viewed as an alternative for paper currency, when, for most of human history, it was the other way around. Paper money was long viewed as a substitute for gold.The big jump of the defensive Consumer Staples sector, from eighth place to third for Timeliness, stands out the most this week. That move is accompanied by a drop in the rankings of the more aggressive Technology sector from second to seventh.
More nuanced advances, of the traditionally safer Utilities and Healthcare sectors, to the second and eighth slots, respectively, also suggest a more defensive posture.
The phrase that beauty is in the eye of the beholder holds no less true of stock price valuations, which can vary considerably over time. Currently, all of the sectors are trading within the ranges set over the past ten years. That indicates no extremes-either bubbles on the upside or recession-fearing valuations on the downside-are evident in the market. Most sectors are near the middle of their long-term ranges, with the exception of the Technology and Telecommunications groups, which sported excessive price tags in the early 2000s.
Notably, the low end of many ranges was set in the last recession, which lasted from late 2007 to mid-2009. Valuations bounced back quickly thereafter, though, in conjunction with the powerful rally that saw the Dow Jones Industrial Average nearly double over that span. However, we note that the median P/E has fallen in recent weeks on concerns that a slowing economy will take some of the starch out of corporate profits.
Tech stocks still offer more overall earnings growth than the other sectors. That is why that group remains the most prized in terms of valuation. But a larger component of Tech's profits is now derived from replacing older systems than was the case in its younger days. Hence, the Technology sector's price-earnings ratio now resembles that of the market as a whole to a greater degree.
The Energy sector's relatively high price-earnings ratio is somewhat surprising. The group normally trades at a lower multiple owing to the uncertainty surrounding the sustainability of oil and natural gas prices. Investors are apparently factoring in strong earnings ahead for the group.
Sectors at the bottom of the list, including Utilities and Consumer Staples, tend to earn consistently low appraisals owing to their relatively unexciting growth prospects. The Financial sector also gets a low price-earnings ratio as a result of the leverage companies in that group use, their reliance on the economy to produce good results, and dependence on volatile interest rates. There have been periods in the past when Financials posted several straight years of mid-teens earnings growth, but still did not generate a premium multiple.
Investors who like to sleep well at night tend to take the longer term view, often selecting good-quality shares that pay dividends and offer measurable growth prospects. (By good quality, we mean stocks that are ranked one or two for Safety by
In our final table, we list the sectors' 3- to 5-year total return possibilities, from highest to lowest, with total return as the combination of stock-price appreciation potential and dividend income. We also provide each sector's beta; the market as a whole has a beta of 1.00.
Our background research indicates that sector dividend yields are clustered around the 2.0% mark that is the market median, except for the Utilities group. What that does is to make total-return prospects highly dependent on appreciation potential. In fact, the sectors currently line up in the same exact order for both appreciation potential and total return possibilities.
Dividends and safety may still make the difference when it comes to investment preferences. The ups and downs of some very cyclical sectors, such as Basic Materials and Energy, are not for everyone. On the other hand, the traditionally defensive Healthcare, Consumer Staples, and Utilities sectors may seem stodgy to others. Certainly, the slow-growth Utilities sector doesn't have the pizzazz of high-flying Tech and Telecom stocks. But it does offer the stability and income that many investors are seeking in this ultra-low interest rate environment.
Comeback candidates include the Consumer Cyclical and Financial sectors. Consumer spending is not as robust as it might be, as a result of high unemployment and slow wage gains. But, assuming the economy continues to recover, spending should rise over time. That might provide the justification for long-term investors to take a position in stocks reliant on consumer spending. Similarly, Financial stocks have the capacity to get back into the good graces of investors. There are some well-run financial companies whose stocks are trading at reasonable valuations that only need an improved economy for share-price performance to pick up.
At the time of this writing, the author did not have any positions in any of the companies mentioned.