Last January I penned a piece supporting the out-performance (click for link) of the health care sector starting out with the bright long term fundamental picture for the sector with the retirement of the baby boom generation, with the following comments:
The above figures show a major shift in the population demographic of the world with many countries moving into the 30%+ category of their population aged 60 years or more. This forecasted shift to an older population will put a major strain on the health care systems of the world and require vast sums of capital investment into hospitals, drug manufacturing facilities, health care equipment manufacturing facilities, and managed care facilities and so on. This backdrop does not necessarily make health care an attractive investment now, as the aging baby boom generation has been discussed for years and the health care sector has underperformed the broad market since late 2002.
However, there are several industry developments that point to strength within the health care sector that may translate into relative out-performance in share prices in the months and years to come, which are discussed below.
So, did the sector outperform the broad market (S&P 500) last year? Yes, but only by 2.34% as energy again stole the spotlight as the best performing sector. This year, though, health care may take center stage as it is vaulting out of the starting gates in 2008.
Figure 1. 2007 Sector Relative Performance to the S&P 500
Image cannot be displayed
Source: Stockcharts.com
One of the reasons the health care sector is likely to do well stems from sector rotation as health care is seen as defensive and benefits from a weak economy. With the economy on the brink of recession, corporate profits for most of the S&P 500 sectors are likely to contract, just the type of environment that benefits the health care sector due to its stable earnings stream.
As seen below, the health care sector’s relative strength (RS) ratio bottomed in early 2000 and soared through the 2001 recession as the operating earnings for the S&P 500 contracted and the stock market fell. During this period the Fed was slashing interest rates to turn the economy around. The health care sector’s RS ratio anticipated the Fed’s move by bottoming prior to the first rate cut and remained strong throughout the rate lowering cycle.
Figure 2
Image cannot be displayed
Source: Moody’s Economy.com
Figure 3
Image cannot be displayed
Source: Moody’s Economy.com
With the economy slowing significantly and both consumer and business confidence falling by the wayside, the breakout in the health care sector’s relative twelve month performance last quarter is not likely to be a head fake but the real McCoy. As seen in the figure below, the health care sector out-performs the market during periods of economic weakness such as the 1991 recession, 1994/1995 mid-cycle slowdown, and the 2001 recession.
Figure 4
Image cannot be displayed
Source: Bloomberg
Health care should benefit from interest from both growth and value investors as not only is health care seen as a growth sector due to its stable earnings, it also should entice value investors as current valuations are far below those seen at the start of the 2000-2001 bull market in the sector.
The figure below is a composite valuation of four price multiples (P/E, P/CF, P/S, P/BV) for the health care sector, which shows the average standard deviation from the mean for the sector. As seen below, health care valuations are near twelve year lows going back to 1995. The sector became undervalued in the 2002 market sell-off and has remained undervalued as money flowed out of the defensive health care sector into transports, industrials, and cyclical sectors as the current bull market began. Not only are price multiples near decade lows, but the sector’s dividend yield is nearly one and half standard deviations above the mean, also supporting the argument of cheap valuations.
Figure 5
Image cannot be displayed
Figure 6
Image cannot be displayed
In addition to cheap valuations and stable earnings, the sector also has specific bullish fundamental supports. For example, though residential construction is in the worst bear market since the Great Depression and commercial real estate is peaking, hospital construction spending continues to reach record levels as is hospital construction spending’s share of total health care construction. Total health care construction spending is reaccelerating with double digit growth rates as hospital construction increases to meet rising demand as the baby boom generation reaches retirement.
Figure 7
Image cannot be displayed
Source: Moody’s Economy.com
Figure 8
Image cannot be displayed
Source: Moody’s Economy.com
Moving on to industry fundamental drivers, with the increase in hospital construction spending will come increased demand for medical equipment used in hospitals, with the health care equipment and supplies industry likely to see increased demand. Additionally, the industry tends to move indirectly with interest rates as the sector’s RS ratio bottomed prior the start of the Fed’s last interest rate lowering cycle in 2000 and subsequently peaking in 2004 as the Fed reversed course and began raising interest rates. The industry’s RS ratio was putting in a bottom as the Fed went on pause and has broken its downtrend recently when the Fed began to slash interest rates late last year.
Figure 9
Image cannot be displayed
Source: Moody’s Economy.com
The biotechnology sector should also stand to benefit from a weak economy as its RS ratio tends to move indirectly with economic activity. The biotechnology industry outperforms the market in periods of economic weakness as seen by its movement relative to the ISM Purchasing Managers Index (PMI), which is shown below on a year-over-year rate of change basis and inverted for visual purposes. There is also a lag in this relationship with a rebound in the industry’s RS likely as the ISM PMI has deteriorated sharply in recent months.
Figure 10
Image cannot be displayed
Source: Moody’s Economy.com
Economic weakness is also associated with falling interest rates and so it is not surprising to see the biotechnology industry’s RS ratio move indirectly with interest rates. With the decline in interest rates and the Fed futures forecasting further Fed rate cuts, the biotechnology industry should out-perform in the coming quarters.
Figure 11
Image cannot be displayed
Source: Moody’s Economy.com
As mentioned previously, the health care sector has taken center stage along with utilities and consumer staples as investors move to defensive sectors amidst economic uncertainty. Consumer staples and health care benefit as non-cyclical retail sales increase relative to total retail sales, with the utility sector benefiting from falling interest rates. Though the utility sector is the top performing sector so far in 2008, it is the most overvalued sector and should have limited upside for this reason, a constraint not shared by the consumer staples and health care sectors.
Figure 12. 2008 Year-to-Date (YTD) Sector Relative Performance to the S&P 500
Image cannot be displayed
Source: Stockcharts.com
Ford Equity Research valuations charts are provided below, showing the sector price-to-earnings bands as well as price-to-sales bands. Health care and consumer staples remain undervalued while the utility sector is at 10-year valuation highs.
Figure 13
Image cannot be displayed
Source: Ford Equity Research
Figure 14
Image cannot be displayed
Source: Ford Equity Research
Figure 15
Image cannot be displayed
Source: Ford Equity Research
One interesting development is the multiple expansion seen in the energy sector last year. Throughout 2003-2006, the bull market in energy was met with disbelief as valuations contracted as share price appreciation did not keep pace with earnings and sales growth. We might be entering the final stage of the energy bull market as multiple expansion signals disbelief turning to belief. When valuations reach all time highs and “new era” talk begins to emerge as it did with technology just before its collapse, we will have reached the mania stage. As valuations are still relatively cheap, the mania stage is ahead as energy still remains the Opportunity of the Decade.
Figure 16
Image cannot be displayed
Source: Ford Equity Research
Today’s Market
The markets deteriorated further today with the Dow, S&P, and the Nasdaq officially undergoing a “correction,” defined as a 10% drop from a recent high. The intraday lows in the markets saw the broad indices down sharply from their October highs with the Dow down 11.9%, the S&P 500 down 12.5%, and the Nasdaq down 15.9% before a late afternoon rally carried the markets into positive territory.
Weighing down the markets initially was Goldman Sachs saying it expects a recession in 2008, with its decision based on economic data over the last few weeks, joining other firms calling for a recession such as Merrill Lynch and Morgan Stanley. The firm’s Chief Economist said on CNBC today that the U.S. is in a recession or will be there shortly.
The late afternoon rally helped the the Dow Jones Industrial Average tack on 146.24 points to close at 12735.31 (+1.16%), the S&P 500 gained 18.94 points to close at 1409.13 (+1.36%), and the NASDAQ rose 34.04 points to close at 2474.55 (+1.39%).
Despite the rally in the market, treasuries rose with the yield on the 10-year note falling 4.9 basis points to close at 3.791%. The dollar index was up, rising 0.30 points to close at 76.41. Advancing issues represented 57 and 47% for the NYSE and NASDAQ respectively, reflecting a mixed market.
