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Today's Market WrapUp 01.31.2007 Mon Tue Wed Thu Fri Puplava Archive
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 (red line, scale on left side of the chart) with the relative strength ratio of the sector shown in black with values corresponding to the right side of the chart. The relative twelve month performance serves as a type of momentum gauge in terms of price performance while the relative strength ratio indicates how the sector is performing relative to the S&P 500. 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 sectors will be presented based on their 2006 performance. Table 1. S&P 500 2006 and 3-Yr Sector Performance
The star performer last year was the telecommunications service sector with a 2006 excess return over the S&P 500 of 18.51%. Reviewing the sector’s twelve month relative performance since 1990 shows the sector underperforming coming out of the 1990 recession with it outperforming from 1992 to the middle of 1993. From the middle of 1993 the sector continued to underperform the S&P 500 until 1997 and continued to advance before peaking in 1999 when it reached a roughly 25% excess return over S&P 500. That year represented a statistical extreme as its twelve month relative performance was just barely two SDs above its mean relative performance. The sector then lost performance momentum relative to the S&P 500 (market) and then began a period of underperformance from the middle of 1999 to early 2004. Late 2005 marked another turning point for the sector as it once again outperformed the market with its twelve month outperformance continuing to trend higher. Looking at Table 1 above shows the sector’s three year performance of 38.97% with the bulk of the performance coming from 2006. Figure 1
The underperformance of the sector relative to the market from roughly 1994-1998 (Figure 1) lead to valuations remaining near fair value, which is represented by the zero line below, except for briefly approaching one SD above fair value in early 1996. From 1997 until 2000 we saw the index soar from roughly 150 to nearly 350 leading to price multiple expansion as the sector began a period of relative price outperformance. Figure 2
The sector became overvalued in 1998 as it was one SD above its fair value and then became even more overvalued by exceeding more than two SDs above its fair value in 1999, a statistical feat that is only seen 5% of the time over a given measured period. This was a clear warning of a correction as the index’s price moved upwards much faster than fundamentals warranted (sales, earnings, cash flow, book value), driving its composite valuation to a statistical extreme. As mentioned already in Figure 1, the twelve month relative performance was also at a statistical extreme at 2 SDs above its average in 1999. With both relative performance and valuation levels at statistically extreme values, investors were wise to take notice and take profits as the index corrected sharply losing roughly 78% of its value from 1999 to 2002 when it finally bottomed. Despite the run up in the sector since late 2005 the sector currently remains near one SD below fair value and is still undervalued leaving room for modest valuation expansion. Coming in second place behind the telecommunication service sector in 2006 was energy. Energy continues to be a strong sector performer as it is the number one ranked sector for the past three year performance, up 104% which corresponds to a 35% annual return over the past three years. Figure 3 below makes it clear why the energy sector has outperformed the market by a wide margin as its twelve month relative performance has remained above 0% since 2000 except for several months in 2003, a very different picture than what was seen in the 1990s with the sector predominantly underperforming the market. Figure 3
The sector’s twelve month relative performance reached nearly 2 SDs below the mean in 1998, marking a statistical extreme as well as the bottom in terms of relative strength (black line). The general trend since 1998 in relative strength has been up which has lead to extended periods of outperformance. The twelve month relative performance reached another statistical extreme, this time an outperformance extreme of two SDs above the mean with a twelve month relative performance value of 35% in excess above the market in late 2004 and into 2005. Since peaking in 2005, the twelve month relative performance has returned to mirror the market (approached zero) even though the relative strength has not lost that much ground, representing more of an extended consolidation rather than a correction as the sector takes a breather. Unlike the bull market that the telecom sector saw in the 1990s that lead to a surge in price as well as an expansion in valuation multiples, the energy bull market this decade has shown a different picture. Since bottoming in early 2003, the sector was up 171% to its high reached in late 2006, yet the composite valuation for the sector has barely and only briefly exceeded fair value unlike the 1990s, which saw valuations reaching nearly three SDs above the mean as cash flow, sales, and book value did not fundamentally support the price level of the sector. Figure 4
With the twelve month relative performance roughly in line with the market and near its mean since 1990, and with valuations still in undervalued territory, the sector has room for valuation expansion and price outperformance going forward. This year may well represent a transition year or breather for the sector as the U.S. economy slows on the back of a housing recession. The point of resurgence in outperformance may come from geopolitical events or a return to above potential growth in the U.S. as it transitions from its mid-cycle slowdown to accelerating growth. Coming in third place last year in terms of performance was the consumer discretionary sector with a 2006 return of 17.23%. Although the sector came in third place last year it has underperformed the market over the past three years with a three year return of 22.8% compared to the S&P 500’s return of 28%. When looking at the sector’s historical twelve month relative performance it can be seen that the sector tends to follow trends in the economy as it should. The sector severely underperformed the market coming out of the 1990 recession and underperformed through the 1994-1995 mid-cycle slow down and turned down once more foreshadowing the 2001 recession. Figure 5
The sector has had mixed performance this decade as it did in the 1990s as it has roughly spent equal time outperforming and underperforming the market. Looking at the sector’s valuation below sheds some light on the performance chart above. The sector reached one SD above its average value in 1998 and went through a sharp correction back to fair value. The sector then bounced back and reached even higher overvalued territory as its valuation reached two SDs above its average value. The sector then corrected in 2000 bringing its valuation back to fair value territory. Figure 6
The sector subsequently flip flopped back and forth from overvalued to undervalued territory from 2001 to 2003, with sharp rebounds in the sector corresponding to periods when valuations were one SD below fair value and corrections when it reached one SD above fair value. Late 2002 and early 2003 saw valuations at one SD below average which marked the bottom in terms of price for the index. Last year marked an important year for the sector as it surpassed its 2000 high and surpassed the performance of the S&P 500. The recent trend change in terms of performance and relative strength may indicate the markets are signaling a mid-cycle slowdown instead of a recession this year. The utility sector came in fourth place last year and in second place behind energy for three year performance. The sector put in a 16.87% return last year and is up 57.7% in the past three years corresponding to a 19.2% annual return compared to the S&P 500’s 9.3% three year annualized return. Although the sector has performed well so far this decade, that can not be said for its performance in 1990s. The sector underperformed the market for virtually the entire decade except for three brief periods. This can be seen as its relative strength line (black line below) was on a declining trend from 1990 to mid 1999. Over the entire period from 1990 to 2006, the average relative annual return for the utility sector was negative 4.4%, clearly a poor investment for the past 16 years. However, the sector had a shining moment as its twelve month relative performance reached just shy of two SDs below its average in 1999. The sector then surged upwards to reach a 45% twelve month return in excess of the market by late 2000. Figure 7
The rebound in performance for the sector came from average valuation levels which then jumped to being greatly overvalued as its valuations reached two SDs above its average by late 2000. It’s no wonder the sector corrected sharply as both its relative twelve month performance and valuations were at more than two SDs above their mean. In the subsequent bear market that ensued, the sector’s valuations went from one extreme to the other as its valuation reached nearly two and a half SDs below its mean by late 2002. The sector then advanced from deeply undervalued levels to one SD above the mean by 2005 and has remained in overvalued territory since, though its relative twelve month performance is currently at par with the market but is trending down. Figure 8
Just behind the utility sector were the financials with a 2006 return of 16.2% and a three year return of 31.1%. Unlike the utility sector, the financials have outperformed the market on average since 1990 with an average 3.9% excess annual return over the S&P 500. This most likely reflects the credit cycle that has benefited the sector handsomely as M3 surged in the 1990s and with an explosion in derivatives and liquidity this decade. The surge in credit helped the sector outperform through most of the 1990s except for earlier in the decade with the 1990 recession, the 1994-1995 mid-cycle slow down, and the surge in the NASDAQ in 1999-2000 that saw money rotate out of most sectors to chase returns in the technology sector. Early 2000 marked a statistical extreme as the sector’s twelve month relative performance reached two SDs below its mean with the sector then rebounding sharply as money poured back into financials with technology stocks crashing, pushing its twelve month relative performance to the opposite extreme at more than two SDs above its mean. Since 2003 the sector has traded in-line with the market as its relative strength ratio has remained relatively flat, which has currently allowed the twelve month performance to move from 2 SDs above the mean to slightly positive. Figure 9
Valuations for the financial sector displayed a significant degree of volatility as shown in Figure 10 below. The sector oscillated from slightly below average value to more than two SDs above average value several times in the later part of the 1990s with valuations between one and two SDs marking important red flags for investors as the sector corrected to bring valuations back to average territory. This pattern continued until 2002 when valuations were compressed even further to greater than one SD below average value which marked the bottom for the sector. Figure 10
Since bottoming in 2002 the sector has not looked back, easily breaching its 2000 highs with valuations still remaining in undervalued territory. A steepening of the yield curve to give it a positive slope would help the sector as it is feeling the squeeze in its margins with the current inversion. A possible Fed rate cut later in the year may be the catalyst the sector needs to see valuation multiples expand and a return to greater relative outperformance after taking a breather with the Fed rate raising cycle that began in 2004. The materials sector came in behind the financials though still above the S&P 500 in terms of 2006 performance with a return of 15.7% and a three year return of 31.8%. Like the energy sector, during the 1990s the materials sector went through a lengthy bear market in terms of relative performance to the market from 1994 until 2000. This reflected the bear market in commodities as the CRB index underperformed the S&P 500 as seen in Figure 12 below. Figure 11
Figure 12
The twelve month relative performance for the sector reached two SDs below its average in 2000 which marked the bottom in its relative strength ratio and also coincided with a bottom in the relative strength of the CRB index relative to the S&P 500. Since then the sector has spent most of this decade outperforming the market with its average relative twelve month performance at 4.6% above the S&P 500. Although the financial sector displayed a great deal of valuation volatility in the late 1990s it was nothing near the volatility seen in the materials sector which reflects the volatility in commodities. The sector oscillated back and forth between overvalued and undervalued territory and nearly reached three SDs above its average value to close the decade. The sector then did an about face and plummeted to nearly three SDs below average value in 2000 to mark the bottom in the sector. Since then valuations have oscillated with an upward trend and remain in overvalued territory. Figure 13
The consumer staples sector underperformed the S&P 500 last year with a return of 11.8% compared to the S&P 500’s 13.6% return. The sector has also underperformed the market on a three year basis with a return of 21.1% compared to the S&P 500’s 28% return. Even though the sector has underperformed the market over the past three years, it has still outperformed the S&P 500 since 2000; it outperformed the market by a 30% excess return in 2000 as the stock market corrected and remained at double-digit excess performance going into 2003 as the stock market bottomed. Figure 14
This pattern resembles the sector’s performance during the 1990s as it led off the decade outperforming the markets as the economy was in a recession. The sector also outperformed going into the 1994-1995 mid-cycle slowdown and continued to outperform until the NASDAQ and broad markets soared and funds rotated out of the defensive consumer staples sector chasing risky assets. Looking at valuation levels for the sector would have warned of a coming correction in the late 1990s as the sector was more than 2 SDs above average value. The bear market in consumer staples from 1999 to 2000 compressed valuations from one extreme to another as valuations reached more than one SD below average valuation and marked the end of its bear market in absolute price as well as relative strength. As money flowed out of consumer cyclicals and technology stocks into consumer staples, valuations were once again driven upwards as the sector reached one SD above average value in 2001. Since then valuations have corrected back to one SD below average value and have remained there since, even though the sector has risen to all-time highs. It wouldn’t be surprising to see the sector’s twelve month relative performance exceed the S&P 500 going forward as its relative performance is trending up with a value currently at 1.72% above the market and valuations still very attractive and the economy cooling. Figure 15
Like the consumer staples sector the industrials underperformed the market last year, though not on a three year basis. The industrials were up 11% last year and nearly 30% over the past three years. The sector put in mixed performance in the 1990s until 1997 when the sector began to greatly underperform the market with its worst performance seen in 1998 with a twelve month relative return of 17% below the S&P 500. The poor performance in 1998 brought its twelve month relative performance to two SDs below its average and foreshadowed a bottom that occurred in the relative strength ratio in 1999. Figure 16
The sector traded in overvalued territory for most of the second half of the 1990s except for the 1998 correction. The drop in share prices from 2001 as the U.S. economy went into a recession to the 2002-2003 market bottom compressed valuations from two SDs above average value to one and a half SDs below average value and marked the bottom for the sector. Like the Dow Jones Industrial Average, the industrial sector broke through its 2000-2001 high while valuations have remained at fair value. Though the sector is not overvalued as its sales, cash flow, and book value have kept pace with its price, its trend in relative performance is down with a current reading of 0.39% and doesn’t appear to be turning around any time soon. Figure 17
The second worst performing sector last year was technology with a 7.7% return, and is the worst performing sector over the past three years with a 10.4% return. This isn’t surprising as the sector experienced a mania with an average annual excess return over the S&P 500 during the 1990s of 11.7%. The sector underperformed the market during the early part of the 1990s and briefly in 1996, but its underperformance paled in comparison to its outperformance. The sector peaked at a twelve month relative performance of 55% above the market in 1999, more than two SDs above its average relative performance before coming back down to earth. Figure 18
The sector imploded as it moved from one extreme to the other with its relative performance moving down to -40% below the S&P 500 in late 2000, nearly two SDs below its average performance. Since the start of 2001 the sector has underperformed the market by 7.6% annualized through 2006. The rally in the NASDAQ late last year may be heralding a return in outperformance for the sector as it has languished since the 1990s. Its twelve month relative performance has turned around and valuations are still attractive unlike the end of the 1990s. Figure 19
The sector jumped from valuations at one SD below average value in 1995 to nearly four SDs above its average value by early 2000. To say technology valuations were at a statistical extreme in 2000 would be a gross understatement. Values greater than two standard deviations from the mean occur only 4.55% of the time, basically a rare event. Values greater than four standard deviations occur only 0.63% of the time, virtually never (assuming valuations are normally distributed)! This shows that the tech bubble of the 1990s was a true bubble statistically. The sector gave back all its gains from 1997 onward before it finally bottomed and valuations were compressed to one SD below the average. With valuations below average and the sector’s relative twelve month performance turning up, 2007 may be the year the sector finally breaks out. Lastly, we come to health care. The sector put in the worst performance last year with a return of 5.8% and second to last worst performance on a three year basis with a 10.7% return just behind technology. The figure below shows that the health care sector outperformed the S&P 500 in the first two years of the 1990s when the economy was coming out of a recession, not surprising as health care is seen as a defensive sector due to its stable earnings. As the economy recovered, money rotated out of health care and into technology and other areas, leading to the performance of the sector to decline and underperform the S&P 500 from early 1992 to 1994, when the economy entered into a mid-cycle slowdown. Not surprisingly, money rotated back into the sector as the economy slowed and the sector continued to outperform until 1998 when the tech bubble moved into full swing and money rotated back into technology. Figure 20
The sector then regained its desirability as the NASDAQ crashed and the economy went into a recession in 2001 where the sector began a period of out-performance from 2000 to 2003, the year the bear market ended. With the end of the bear market, money then rotated back out of the sector and health care has continued to under-perform since then except for a brief period in 2005. Figure 20 above shows that the health care sector outperforms on a twelve month relative basis when the economy is in either a recession, or undergoing a mid-cycle slowdown due to its stable earnings. Looking at valuations from 1995 to 2000 and from 2000 to the present shows two completely different pictures. As the sector advanced from 1995 to peaking in 1999, valuations expanded indicating that price was advancing at a greater rate than fundamentals to drive price multiples higher. The sector reached more than two SDs above its average value in late 1998 which was a warning signal for a correction to come that drove back valuations to near average value in early 2000. Valuations reached overvalued territory in early 2001 and then compressed sharply to one SD below average value in 2002. As the sector bottomed and has advanced since then, valuations have actually compressed even further, indicating that in this decade fundamentals have risen at a faster rate than price. Figure 21
With valuations quite low and the economy slowing, this defensive sector may reverse course to finish near the top of the pack in performance this year after languishing behind over the last few years. For those interested in further information supporting the case for health care outperformance, please read an article written a few weeks ago (Health Care Macro Investment Theme, 01.17.2007) Sector Analysis Summary In review of the above commentary and figures, it can be seen that statistical extremes in terms of SDs from the average value, whether that is relative twelve month performance or valuations, often mark turning points as either bottoms or tops. As such, an effective investing strategy would look for undervalued sectors that were oversold (in terms of relative twelve month performance) and would avoid overvalued sectors that were overbought. The valuation and relative performance for each sector is summarized below in Table 2. Table 2
Based on the above table, the most attractive sector is health care as it remains undervalued and is slightly oversold and is already off to a good start as it has the second highest year-to-date (YTD) return at 2.23%. The worst sector investment would be utilities which remain overvalued and slightly overbought. It will be interesting to look back at the end of the year to see if the investment rank in Table 2 corresponds with price performance rank; time will tell. TODAY'S MARKET - Economic Reports GDP – 2006Q4 The Bureau of Economic Analysis released the numbers for fourth quarter 2006 gross domestic product (GDP), which showed the economy grew 3.5% on an annualized basis, up from the third quarters 2.0% growth rate and higher than the 3.1% consensus expectation.
The largest drag on GDP has continued to be residential fixed investment, which was down an annualized 19.2% from the third quarter and has been in a downtrend since peaking in the second quarter of 2005. By component percent contributions to real GDP, the highest contributor was personal consumption expenditures, which added 3.05% to real GDP and was up an annualized 4.4% for the quarter. Surprisingly, net exports were the second highest contributing component to GDP by adding 1.64%, with exports up and imports down an annualized 10.0% and -3.2% respectively. Also adding positively to GDP were government expenditures, adding 0.70% and up 3.7% on an annualized basis.
The major drag on GDP was fixed investment which reduced GDP by 1.92% and was down an annualized 7.3%. The biggest drag on fixed investment was residential investment, not surprisingly, down an annualized 19.2%. However, what was alarming was nonresidential fixed investment that includes categories such as structures and equipment and software. Nonresidential fixed investment turned negative in the quarter and was down an annualized 0.4%. This is alarming because in the previous quarter, nonresidential investment was up an annualized 10.0% and had been helping to offset the negative contribution of residential investment to total fixed investment and now adds to the decline in fixed investment. The last time nonresidential fixed investment was negative on an annualized basis was in the first quarter of 2003. It first turned negative in the last economic expansion in the first quarter of 2001, right when the last recession began.
Note in the chart above that as the recession of 2001 was underway housing had rebounded and contributed positively to GDP except for a brief period in late 2001. The chart above indicates that business spending in terms of nonresidential fixed investment was one of the main contributing factors that lead to the recession; this time it's housing. Housing has turned much lower on an annualized basis compared to the 2001 recession where housing bottomed at a -8% annualized rate; we are currently seating on a -19.2% rate. Also note that nonresidential fixed investment is nearing a level close to that seen in the beginning of the 2001 recession. Another observation I would like to point out is that consumer spending had slowed along with fixed investment heading into the last recession though it stayed positive throughout the recession (figure below). With personal consumption expenditures running adding 3% to current GDP, the consumer is offsetting the negative contribution from fixed investment and will need to stay positive to keep GDP growth above recessionary levels. Thus, the consumer is currently underpinning the economy and more than offsetting a negative housing market and weak business spending and will have to be monitored closely to serve as warning of any coming recession.
Construction Spending (C30) In other news, the Bureau of Census released construction spending for December, which decreased 0.4% and came in at $1.177 trillion, down 1.4% from last year’s levels.
The decrease in November came from a 1.6% decline in private residential construction, which is down 1.9% over last year’s levels. In stark contrast to private residential construction, private nonresidential construction increased 0.9% in November and is up 16.2% over last year's levels.
MBA Mortgage Applications Survey Mortgage demand rose to break a two week declining trend, rising 3.2% last week with both purchase applications and refinance applications rising 1.3% and 4.9% respectively. The contract rate on the 30-yr FRM increased 7 basis points to 6.29% with the 1-yr ARM falling, down 5 basis points to 5.86%. |
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