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Sector Analysis - August 8, 2012
Investors who want to look at the "big picture" often start by examining the state of the 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 sectors we follow, which include nearly 100 industries, highlighting any notable changes. The sectors 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. This report also reviews updated sector 3- to 5-year appreciation potential, dividend yields, and beta coefficients.
From the nearby table, we see there has been several shifts in sector positions since our March report, with the most notable being the rise in Basic Materials to first for Timeliness, from third. The Basic Materials sector is on the small side, consisting of just seven industries and 93 companies. The most highly ranked industries in the sector are the Chemical (Diversified) and Chemical (Basic) groups, whose profits are benefiting from low natural gas prices.
At this point it is worth noting that the economy is most likely in the middle part of a business cycle. All business cycles are a little bit different, but certain sectors perform best in particular stages. For instance, the Basic Materials and Industrial sectors have historically done well in the early part of an expansion, as investors anticipate a pickup in product demand. Interest-rate sensitive stocks, such as financials and those in the consumer cyclical group, also often outperform in the early part of a recovery, owing to lower interest rates. The difference this last time around was that the Financial sector lagged for a long time in the wake of the 2008 banking crisis.
In the latter stages of a business cycle, meanwhile, basic materials and energy stocks frequently do well, in part as a hedge against rising prices and inflationary pressures. During recessions, of course, it is well documented that the Utilities, Consumer Staples, and Healthcare sectors hold up best. But some research suggests that the variation between sectors may not be as pronounced during the middle part of a business expansion.
While well below the market's high of 185% in early March of 2009, an 80% return (excluding dividends) out to 2015-2017, if achieved, would represent an annualized return of better than 15%. The possibility of realizing such sizable returns is precisely why stocks hold their attraction. Those types of gains are enviable, even in normal times, let alone nowadays with interest rates paying next to nothing. Topping the list for capital gains potential is the Energy sector, comprised of six industry groups and 95 companies. Suffice to say, signs of a pickup in the business conditions would be a plus for oil prices and this economically sensitive group.
Next up is the Technology sector. The tech group is not big in terms of the number industries, with seven, and only medium-sized with respect to the number of companies, with 149, but it nevertheless possesses the largest combined market capitalization of all sectors. That is an indication of Tech's relatively high price-to-earnings ratio, supported by the type of innovation that has given rise to companies such as Apple (AAPL) and Google (GOOG), which have captured the public's imagination with their products in recent years. Comparatively high valuations for information technology stocks suggest investors believe that more new ground will be broken in the years to come, though the prospects are not without risks.
Safety And Income Have A Place
There is some evidence to suggest that individual investors have been shying away from stocks in recent years, as the financial crisis and incidents such as the May 2010 "Flash Crash" have worked to undermine confidence. Now Europe is a major concern. But as long as the economy is growing, even at a modest pace, and stocks are reasonably priced, as they now seem to be, investors have a chance to do well. And, clearly, stocks have a place in the portfolios of income-oriented investors.
Careful stock selection is always in order, of course. We have always recommended that investors looking for current income also consider a particular stock's Safety rank. The order of the sector Safety ranks roughly corresponds to their Beta coefficients, shown in the nearby table. Note that the recession-resistant groups (Utilities, Consumer Staples, and Healthcare) each have Betas lower than the overall market (1.00). Conversely, high-Beta sectors (Basic Materials, Energy, Consumer Cyclical) are more likely to be favored during boom times.
It should be noted that Betas change over time. Our research shows that, ten years ago, in the wake of the bursting of the bubble in technology stocks, the Tech sector had a beta of 1.57. As seen in the above chart, the tech sector's Beta is down to 1.12, indicating much less volatility. On the other side of the coin, the Financial sector in 2002 had a beta that nearly matched the market's 1.00. That sector's higher Beta these days reflects the turmoil financial companies have undergone these past few years.
Dividend yields have also shifted. In 2002, tech stocks yielded an average of just 0.9%, versus the 2.8% they now collectively offer. The higher payout is another indication of the group's maturity and increased stability. At the same time, the Financial sector once yielded 3.2%, but that figure is now lower. Utilities are still the best dividend payers, although the yield on that group has fallen from 5.6% in 2002 to 4.2% now. Utilities have been generally increasing dividends, but the sector yield is lower because its price-earnings ratio is 30% higher, as investors place greater value on income-producing stocks.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.