Thursday, October 01, 2009
I recently completed a simple analysis of the S&P 500 that argues strongly for a shift in leadership in the market. I computed the 6-month total returns of all stocks in the S&P 500 and then compared the top 250 performers with the bottom 250. Here are my findings. Performance Metrics Total Return Last 6 Months: The top 250 performers, a preponderance of which are cyclical stocks, produced a median total return of 75.2%, compared to a median total return for the bottom 250 (mostly stable-growth companies) of 15.8%. This amazing performance of the cyclicals (consumer cyclicals, financials, industrials, materials, and techs) over the last six months needs some clarification. Randy Alsman, one of our portfolio managers, coined the term "survivors' bounce" in the early days of the current upturn in stocks. At one of our investment meetings, after it was clear that the market had turned, he noted that the stocks that were performing the best week after week were the same stocks that had fallen off the cliff from October of 2008 through March 2009. His line of thinking went like this: When investors thought that another 1929-type depression was a sure thing, they abandoned almost all cyclical stocks. As the Fed pulled out all the stops to under gird the banking system, and as it became clear that the big banks were not going to fail, investors returned to the bombed-out cyclical sectors and began to buy. Thus, the incredible performance of the cyclical stocks as revealed in the performance of the top 250 stocks over the last six months has been a rebound from their incredibly bad performance in the prior six months. This can be seen in the next data point. Total Return Last 12 Months: Holding constant the stocks in the top 250 and bottom 250 groups over the last 6 months and extending their performances to 12 months, we see a very different picture. The top group produced a total return of -9.3% compared to a median return of -9.4% for the bottom group. The remarkable performance that the cyclical stocks have achieved over the last six months has only brought them back to equivalency with the more stable-growth stocks (consumer staples, health-care, energy, and utilities) for the 12 month period. The twelve month data vividly show how badly the cyclical stock got banged up from October of 2008 through March of 2009. But if the last six months has been so good for the cyclicals, why can't it continue? The reason is in the valuation metrics. Valuation Metrics Trailing PE: The median trailing PE for the top 250 stocks is currently 23.7, while the PE for the bottom 250 stocks is 15.8. The top group would appear to be pricing in an awful lot of good news. Let's look at the long term earnings estimates to see if it is justified. Long Term Earning Growth Estimates: Analysts are estimating the top 250 stocks will achieve median earnings growth over the next 3-5 years of 9.6% per annum. That is virtually identical to the predicted growth rate for the same period of the bottom 250 stocks of 9.5%. The bottom line on my analysis is simple. The cyclical stocks, which have been leading the S&P 500 in its remarkable run over the last 6 months, are running out of valuation gas. For the cyclical sectors to continue to lead stocks higher from here would require dramatic increases in their predicted 3-5 year earnings rate of growth. I don't believe that will happen. In my judgment, that means that savvy investors may soon begin to move back to the much cheaper stable-growth sectors. There are question marks in some of these stable-growth sectors, particularly in health care and utilities. Both sectors have been held back by the uncertainties in the ongoing debates on health care and cap and trade, respectively. I believe in both cases, however, the final legislation will be less damaging to these two industries than is now priced in. Stable-growth companies are where you find the great long-term dividend growers. Our Dividend- Valuation models indicate that companies like Procter and Gamble, Johnson and Johnson, McDonalds, Abbott Labs, Pepsico, and Nestle are as much as 35% undervalued. They performed much better than the average stock last year but have been idling most of this year. I believe that will change as more and more investors become aware of the valuation gap between the stable-growth and cyclical-growth stocks. As Randy Alsman recently said, "The survivor's bounce" is coming to an end. We own all the stocks mentioned here. See the Terms and Conditions.