“I rob banks because that’s where the money is.” attributed to Willie Sutton, bank robber
“I was misinformed.” Humphrey Bogart as Rick Blaine in Casablanca
Each bull or bear market seems to have its own leadership, a major group or sector that outpaces the general market and sets the tone for the era. While this may sound like the statement of a technician, in reality, it is a function of the fundamentals or at least the market’s perception of those fundamentals.
Significant expansions or contractions in segments of the economy are projected onto Wall Street and enlarged by the beliefs and passions of investors. As industry conditions improve, corporate managers, who might have been cautious at the beginning, become more confident. That confidence, if rewarded by better results, can morph into recklessness as growth persists beyond fixed expectations. Unfulfilled predictions of doom seem to give an expansion the appearance of timelessness and fuel the fire. When the inevitable slowdown comes, it usually finds corporations very ill-suited to deal with it. The industry often continues to expand even as the painful reality sinks in. This exacerbates the downturn in fundamentals and leaves a legacy of lingering over-capacity.
Meanwhile, on Wall Street, investor perception follows a similar path. Sentiment moves from concern, to confidence, to complacency and on to euphoria. Like an investing version of the classic stages of grief, the downturn brings denial, concern, tenacity and, eventually, capitulation.
Nobody is happy at the end. Corporations are left with ravaged balance sheets and bloated capacity. Investors are poorer, disenchanted and exhausted. However, while they may want no part of the industry now, they still remember the good times. Many would be happy to try to get some of their money back, if only the area would come to life again.
The above scenario has been played out a number of times in the last 35 years.
Energy boomed in the late 1970’s and 1980. The energy sector was almost single handedly responsible for significant bull market in the first 11 months of 1980. At the peak, it represented over a quarter of the S&P Composite’s market capitalization.
Its collapse in 1981 led to a bear market lasting until August of 1982. Interestingly, in the first twelve months of the new bear market, energy was the best performing large capitalization sector in the market. However, after that initial rebound, the sector lapsed into an extended period of insignificance and underperformance that lasted almost into the twenty-first century.
Technology was a massive winner in the late 1990’s. A combination of internet frenzy, Y2K fear and Fed stimulus (after Long Term Capital’s problems) fed an enormous run-up in a number of issues. Technology was the vanguard of the “Roaring 90s.” At the peak, it represented over a fifth of the S&P Composite’s market capitalization.
When near impossible expectations could not be met and business slowed, the sector was the first and greatest loser in the bear market of 2000-2002/3. However, when the market rebounded, technology was the best performing sector of 2003. It did not last. Technology was the next- to worst-performing sector in the next three years and underperformed the market in six of the next eight years. The sector stagnated as the benefits of its innovation flowed from those who created it to those who consumed it.
It appears that the most recent sector to follow this pattern is the financials. While not as dominant as energy or technology, the financials sector reached a market capitalization in early 2007 of nearly three trillion dollars, or about 22% of the S&P 500. Then the problems began.
The sector and its problems led the market down in 2007 and 2008. However, in early 2009, as the broad market recovered, financials outperformed by more than 50% in a six-month period.
Since then, the sector has underperformed the market in 2010 and finished at the bottom of the heap in 2011.
At first glance, it would seem that, after so much time and so much underperformance, the sector deserves at least some attention. Indeed, as Europe has shown recent signs of short-term stabilization, many seemingly depressed financial names have begun to outperform sharply.
While we certainly would like to participate in the rally and buy stocks that are down, we are keeping our distance for three reasons:
- History argues that it is too soon. As mentioned above, the last two major sectors to behave like the financials (energy and technology) spent many years in the penalty box. It took a long time in the past to “burn through” all of the issues created by the “boom.” Energy was a laggard for almost 15-20 years after its peak. Technology is still a mediocre performer 12 years after its blow-off. It has been five years since the financials started down. Maybe that is enough, but seems a bit premature to expect the beginning of an industry expansion. There are also a number of regulatory and asset-quality issues that seem far from resolved.
- The sector does not appear to be cheap compared to projected earnings. Figure 1 is a history of the financials sector’s relative P/E (vs. the S&P Composite) based on then-consensus expectations. The reader will note that at a 15-20% discount to the market, the financials sector is at or near what has been the upper end of its valuation band for the last 15 years (the spike in 2009-10 was a function of greatly and obviously depressed earnings, not valuation expansion). As an aside, the asset-quality issues mentioned above would tend to refute a valuation argument based on a low price-to-book.
Past performance is no guarantee of future results.
- Relative earnings momentum appears to have peaked after a sharp rebound and has been growing no faster than the market’s. Figure 2 is a history of the sector’s relative price and earnings performance. As mentioned in the above bullet point, earnings expectations, which were unusually depressed in 2009, rebounded in early 2010. Since then, they have grown at the market’s pace. While relative earnings expectations appear depressed compared to those in the early 2000s, it seems unlikely that they will be recaptured soon. The implicit risks in many of the business models that produced those earnings and the strict regulatory protocol of today (and, probably, tomorrow) seem to preclude that possibility.
Past performance is no guarantee of future results.
Our commentary is painted with a broad brush. A well and prudently run company can prosper, and its stock should appreciate in even the most difficult environment and blighted sector. We recognize the massive underperformance that has afflicted the financial sector in the last five years and acknowledge that its recent outperformance could continue for a brief period; however, in general, we prefer to remain on the sidelines until more time passes, valuations improve, or a path to the sector’s eventual recovery becomes clearer.