Past performance is not indicative of future performance… Or is it?
While no one can tell you precisely what the weather will be three months from now, we can look back at past seasonal patterns and postulate reasonably well what the climate will be like.
That can be done with equities, too — especially groups of stocks lumped together into sectors. Since each sector benefits from certain economic conditions and suffers during certain others, we can gather some insight into future performance by locating similar economic periods in the past and noting how the sectors performed then.
Chances are pretty good the sectors will behave similarly when the same season comes around again.
Let’s take a look at two such comparisons to see what the future might have in store for the various sectors — first over the near term, and then over the longer term.
Near-Term Corrective Season
A recent analysis by investment research group New Constructs LLC evaluated each sector according to the health of the mutual funds and ETFs it contains.
Funds were scrutinized “based on rigorous analysis of the profitability and valuation of each fund’s holdings,” the firm explains, and were then rated on a scale ranging from “Very Attractive” to “Very Dangerous.”
The ratings of all funds are then combined to determine the attractiveness or danger of each sector overall, as tabled below.
Data: New Constructs LLC
To earn the Very Attractive and Attractive ratings, “an ETF or mutual fund must have high-quality holdings and low costs,” the firm defines.
Of the hundreds of sector funds examined, only one earned the Very Attractive rating: the PowerShares KBW Property & Casualty Insurance Portfolio (NYSE: KBWP), which belongs to the Financials sector.
Consumer Staples is the only sector with funds that meet the criteria of Attractive, a full fifth of the sector’s fund population. And that was pretty much it for the good ratings; it was all downhill from there.
The Consumer Staples sector also tops the list in the Neutral category, with more than half of its funds belonging to it. The Industrials sector placed next with 40% of its funds rated as Neutral, followed by the Discretionary sector with 31% of its funds stamped so.
Now we get into some risky business. The Dangerous and Very Dangerous categories include funds and ETFs that run the risk of “blowing up,” as the stocks that comprise them are either terribly overvalued and/or have poor earnings prospects.
Topping the Dangerous category is the Materials sector with 85% of its funds at risk, followed by Discretionary and Energy, each with 69% of their funds in the danger zone.
Topping the Very Dangerous category is the Utilities sector, with 88% of its funds rated as teetering on the verge of implosion.
To get a better idea of which sectors are the most dangerous, I added an extra column combining the Dangerous and Very Dangerous categories together and then sorted the nine sectors according to this Dang and Very Dang combination. Ouch, what a lethal mixture this produces.
The most lethal is the Utilities sector, with all of its funds — a full 100% — in the Dangerous and Very Dangerous categories, followed by Energy with 99% of its funds walking on death row, and the Materials, Financials, Health Care, and Technology sectors close behind.
The safest sector to be in at the moment appears to be Consumer Staples, with only 26% of its funds in the Dang and Very Dang predicament.
This tells us something… the majority of the sectors, and the majority of the funds within them, offer terrible value at the moment. Every sector save one has more than 60% of its funds rated as risky, while six of the nine sectors have more than 80% of their funds rated as highly risky.
A near-term correction may thus be closer than we realize. Investors may wish to take refuge in the safe harbor of Consumer Staples, comprising such stocks as basic foods, personal products, and discount retailers.
Or you might simply opt for a Consumer Staples sector fund, such as the SPDR Consumer Staples Select Sector ETF (NYSE: XLP), whose top five holdings include Procter & Gamble (NYSE: PG), Coca-Cola (NYSE: KO), Philip Morris (NYSE: PM), Wal-Mart (NYSE: WMT), and CVS Caremark (NYSE: CVS).
What should we avoid? Pretty much everything else. But don’t be fooled by a sector’s valuations, because in times of uncertainty, stock prices can become distorted as investors shift their holding en masse.
Just note the following valuations by sector, as derived from the SPDR Select Sector ETFs:
I inserted the Dang & Very Dang column from the previous table to illustrate the shifting of investment capital. Under normal circumstances, we would see a low Price to Earnings ratio as attractive, as an indication that such companies or funds are undervalued and ripe for the picking. But not this time.
What these Price to Earnings ratios are telling us is that investors have been moving their money out of the dangerous sectors and into the safer ones. Note how the highest P/E ratios line up with the least dangerous sectors, while the lowest ratios line up with the most dangerous sectors.
The flight out of danger is leaving some attractive valuations in its wake. But now is not the time to jump into those waters. The smart money is moving into the safer zones, and we should be there, too — even if the shift has driven up their stock prices to higher multiples.
The only exception here is Health Care. Its high P/E multiple does not come from investors seeking safe haven, but simply from running too hot for too long. It should be avoided, along with the sectors listed beneath it.
Longer-Term Seasonal Shift
Yet we get a different picture when we look out over the next two to five years and match them up with a similar season from the past. The sectors get shuffled around quite a bit.
Once we get past the turbulence of 2014 brought on by the winding down of the Federal Reserve’s bond-buying program, the American economy will next enter a season of rising interest rates — likely running from 2015 until rates are normalized at the 4 to 6% level by 2020 or so.
To get a sense of how the sectors might perform during the upcoming rate-rising period, we need to find a similar season of rising interest rates in the recent past.
The 2004-07 period will do just fine, as noted in the graph below. (It may seem a rather daunting graphic, but we’ll get through it piece by piece.)
Click to Enlarge
Sources: BigCharts.com & TradingEconomics.com
Plotted on the two graphs at the top are all nine SPDR sector funds along with the S&P 500 index on a monthly scale. To the left is a five-year graph from 2004-09, while to the right is another five-year graph from 2009 to present. (I had to break it up in order to reset the point of origin to 0% at 2009 and thus separate the performance of the two five-year periods from each other.)
The blue boxes correspond to the last period of rising interest rates from 2004-07. During that time, five sectors beat the S&P 500 broader market (Energy, Utilities, Materials, Industrials, and Financials), while four sectors lagged the broader market (Discretionary, Technology, Staples, and Health). [Also listed at the bottom right corner.]
We might postulate, therefore, that during the next period of rising interest rates from 2015-20, the sectors could very well perform much as they did from 2004-07. Yet this is quite the opposite of how the sectors have been performing lately in the low interest rate environment since 2009.
In our current low rate season, only three sectors have outperformed the S&P 500 (Discretionary, Industrials, and Health), while the other six have underperformed the broader market. Of these six underperformers, four stand out as potential buying opportunities — tagged by the green dots (Financials, Energy, Materials, and Utilities).
While these have underperformed the S&P during the present low interest rate environment, they should outperform the broader market when interest rates start to rise — much as they did the last time rates rose from 2004-07.
At the same time, the sectors currently outperforming the market in the present low interest rate environment could take a turn for the worse when rates start to rise — namely Discretionary and Health Care, as tagged by the yellow dots.
These suffered when rates rose last time, and they could again when the interest rate season shifts the other way.
Two Game Plans
On a sector basis, then, it looks like we may have two game plans in our playbook. Over the immediate term, note those Dang and Very Dang sectors to avoid. Even in weather, there is a turbulent transition period as seasons change.
Once the transition from low interest rates to rising rates is made, the sectors could be due for a reshuffling, possibly returning to their 2004-07 order of performance. These should make good longer-term investments — once we get past these dang near-term dangers.
Until next time,
Joseph Cafariello for Wealth Daily
