Sunday, July 20, 2014

The leadership surprise in this bull cycle

Weekly Trend Model signal
Trend Model signal: Risk-on
Direction of last change: Positive (for an explanation, see An intriguing Trend Model interim report card).

Looking for leadership in the current bull cycle
It is a truism among technical analysts that each bull market is characterized but different kinds of market leaders. After the bull peaks, the old market leaders fade and new leaders take the baton.

As examples, the bull phase of the late 1970`s was marked by hard-asset, inflation-hedge leadership such as Energy and Materials. As a reminder of how difficult it is for former leaders to recover, the poster child of inflation-hedge vehicles, gold, peaked out at $850 in early 1980 and went into a long bear phase that did not bottom out until 2001.

The next bull cycle was characterized by consumer stocks, first the Consumer Staples and the enthusiasm spread into Consumer Discretionary companies. The shares of these companies was driven by the LBO-boom, fueled by junk bond offerings. (Recall Robert Campeau and his junk-bond fueled takeovers of Federated and Allied Department Stores and how it all came crashing down on him.)

The bull market of the 1990`s was the TMT era - Tech, Media and Telecom. The Four Horsemen (Intel, Cisco, Sun Microsystems and Oracle) boomed and it all ended with the NASDAQ peak in March 2000.

The lesson for investors is, "Once a bull market ends, don't cling to the leadership over the previous bull cycle. Look for new leadership." As an illustration of this principle, consider this 15-year chart of the relative performance of Technology stocks relative to the SPX. The sector peaked out with the NASDAQ in early 2000, tanked and has been in a sideways relative consolidation phase for over a decade. While the relative uptrend (shown by the blue arrowed trend line) shows some promise, this sector is unlikely to be the next market leaders for some time. Telecom stocks (not shown) also display a similar pattern of rise, fall and sideways relative consolidation.

Previous leaders falter
So what are the leaders in this bull cycle? I would not look for them among the last bull cycle's leaders. Here is the relative performance chart (all 15-year time frames) of Financials against the market. The relative performance pattern of this sector looks like the Tech sector, but pulled forward by a few years. Financials appear to be undergoing a sideways relative consolidation pattern.

The bull market of the early 2000s was marked by the revival of hard-asset plays. Here is the relative performance chart of the Energy sector. While Energy did not crash as the Financials did in the aftermath of the Lehman Crisis, this sector is either making a broad relative top by rolling over or, more charitably characterized as undergoing a sideways relative consolidation. No leadership here.

The relative performance of the other hard-asset sector, Materials, show a similar pattern of either relative rollver or sideways consolidation.

What about gold and gold stocks, the bellwether inflation hedge vehicles? When I look at the relative performance chart of HUI against SPX, the most likely conclusion is that the best days for this group are in the past and not in the immediate future.

These last three charts suggest that the bull phase of the Commodity Supercycle is largely over.

Looking for the new leaders
Once we have ruled out past leaders, we then look for the new leadership among other candidates. The cyclically sensitive Industrial stocks don`t appear to be the new leaders, as they remain in a broad sideways relative range against the SPX.

A case could be made for the Consumer Discretionary sector, but the knock against these stocks are 1) relative outperformance in the past couple of episodes appear to be cyclical and not secular in nature; and 2) these stocks are starting to falter as they recently breached a relative uptrend. If we accept the premise that Consumer Discretionary stocks constituted this cycle`s secular leadership, then the conclusion is this bull market is over. Kaput!

The healthcare surprise
There are only 10 GICS sectors and the sectors that are left are thought to be defensive in nature: Utilities, Consumer Staples and Healthcare. Relative performance charts of the first two, Utilities and Consumer Staples, do not reveal them to be the market leaders. This bull market`s leadership appears to be (surprise) healthcare.

While healthcare stocks are generally thought to be relatively stable and defensive, there is one growth industry within the sector: Biotechnology (sorry, Janet Yellen). In the past decade, we have seen an amazing number of life extension technologies being announced and worked on in the Biotech industry. As a consequence, the Biotech and Healthcare space are good candidates to be the market leaders for this bull cycle.

From a technical point of view, the Biotech stocks appear to be just getting started. The relative performance chart of IBB against SPY shows that IBB only staged a relative breakout out of a long base lasting over a decade. That`s a formula for much more relative gains.

Despite Janet Yellen's recent comments about stretched valuations in Biotech stocks, CNBC reported that Mark Schoenbaum, who was the top ranked biotech analyst for the past nine years according to Institutional Investor, pushed back on Yellen's comments in a recent published report:
"Dr. Yellen — Thank you for sharing your thoughts recently on the biotech sector. … You stated that biotechnology valuations are 'stretched, with ratios of prices to forward earnings remaining high relative to historical norms.'"

As evidence, Schoenbaum included Russell 1000 data from biotech stocks dating back to 1978, "and my data show that the current ratio is roughly in line with the historical median and is approximately 40% below the peak.

"Please tell me what I'm missing, Dr. Yellen," he wrote.

Schoenbaum added that he had a "great deal of respect" for Yellen.

"However, we have a different view, perhaps, of the data on price-to-earnings ratios," he said.

Schoenbaum called biotech is "a large, large sector" with hundreds of companies, "most of which have no profits and no earnings. They're basically options vehicles based on a drug that will report data out in a few months. And certainly, in 2012 and 2013, it was an unprecedented bull run in biotech. For some of those stocks, there's probably too much optimism baked in.

"But of course, in the giant universe of biotech stocks, you're going to find stocks that are overvalued and you're going to find some that are undervalued."

More room for this bull to run
Since market leadership generally changes when a bull market ends, then the longevity of the run in Healthcare and Biotech is a function of the health of the current bull run. Despite my concerns about valuation (see More evidence of a low return equity environment), I believe that this bull market is long from over. Even Jeremy Grantham, who has been known as a value investor, is postulating a M+A driven market bubble for the stock market:
These are my reasons. First, when compared to other deal frenzies, the real cost of debt this cycle is lower. Second, profit margins are, despite the first quarter, still at very high levels and are widely expected to stay there. Not a bad combination for a deal maker, but it is the third reason that influences my thinking most: the economy, despite its being in year six of an economic recovery, still looks in many ways like quite a young economy. There are massive reserves of labor in the official unemployment plus room for perhaps a 2% increase in labor participation rates as discouraged workers potentially get drawn into the workforce by steady growth in the economy. There is also lots of room for a pick-up in capital spending that has been uniquely low in this recovery, and I use the word “uniquely” in its old-fashioned sense, for such a slow recovery in capital spending has never, ever occurred before. The very disappointment in the rate of recovery thus becomes a virtue for deal making.

Previous upswings in deals tended to occur at market peaks, like 2000 and 2007, which in complete contrast to today were old economic cycles already showing their wrinkles. Worse than being in full swing, they were usually way over capacity. Thus, 2000 was helped along by the bubble in growth stocks to over 60 times earnings, allowing companies like Cisco, possibly correctly, to believe they were dealing with a near-zero cost of capital in making deal after deal for their massively overpriced stock.
Bull markets end in one of two ways, recession or a correction from excess valuation (1987, 2000 for NASDAQ). There are few signs of a US recession in the near future. Grantham wrote that the US economy "looks in many ways like quite a young economy" with more expansion potential in the future. As well, the latest review of high-frequency economic indicator from New Deal Democrat is also pointing to continued strength.

While valuations appear somewhat stretched, any market downturn needs a trigger. I have expressed some concerns about the possibility of an EPS growth scare. However, the early indications from Bespoke show that EPS and revenue beat rates this earnings seasons are at or above historical norms.

If Healthcare and Biotech are indeed the new leaders of this market cycle, then we need more excesses to build before this bull run is over. One sign is the sector weighting of Healthcare. Bespoke reports that Healthcare only represents the third highest weight in the SP 500. Before the bubble pops, we need to see this sector to get to at least the second largest weighting, or perhaps the top weighted sector in the SP 500.

Given the technical picture of the relative upside breakout of Biotech stocks and the sector weighting position of Healthcare, these stocks may have a lot further to run.


Anonymous said...

great post.

Anonymous said...

Great post. Thank you.

Tin said...

So... aside from biotech, how is the rest of the sector performing?

Cam Hui, CFA said...

The other non-Biotech groups are generally in relative uptrends. Pharma is one of the strongest groups on a relative basis.