The current market is starting to look a little tired. It's getting harder and harder to make significant money in the stocks and sectors that have led the stock market in performance over the past five years.
It's time to think about the next market, to think about what stocks and sectors might be most profitable to own over the next five years.
I don't think the overall stock market is out of the woods quite yet. The major averages such as the Dow Jones industrials ($INDU) and the S&P 500 Index ($INX) seem intent on testing their March lows. For the Dow, the closing low was at 11,740 on March 10. That's about 3.3% below the 12,142 close for the index June 12.
If stocks come near that low but don't penetrate that level and instead bounce off it, I think we will have gone a long way toward putting in a bottom in the market slide that began in October and has ruled stocks pretty much ever since. A successful test of the March low wouldn't remove all my worries about stocks -- given what looks like an extended bout of interest-rate increases around the globe between now and the first quarter of 2009 -- but would lower the odds that we still have a big bear market ahead.
If stocks continue to give ground, as they have since the May 1 closing high at 13,010, and the indexes fall through their March 10 lows, then the market still hasn't found a bottom. And I'll remain worried that we're in the early stages of a bear market with the worst quite possibly in front of us.
The leaders lagBut when I say this market is looking tired, I'm actually talking about something quite different from these hopes and worries about the direction of the general market. All markets, rising and falling, have sectors and stocks that outperform the market.
We say that these sectors and stocks lead the market. In a rallying market, they outperform all other stocks. In a falling market, depending on the severity of the overall decline, they either fall less or actually go up in price when other stocks are falling.
For the past five years or so, this market has been led by energy and commodity stocks with occasional important contributions from gold and transportation stocks. The returns on these sectors have been stunningly better than the market as a whole. The energy sector, as measured by the, returned an annual average of 29.44% a year for the five-year period that ended June 11. That beats the return on the broad-market S&P 500 by a huge 21.45 percentage points a year.
You can also see the value of owning market leadership if you look at shorter periods. For example, in 2004, when the S&P 500 returned just 8.97%, the energy sector exchange-traded fund returned 33.87%. That's leadership.
But recently that old leadership of energy, commodity and gold stocks seems stuck in a rut, or worse. You can see that if you look at the relative-strength rankings of stocks in these old leadership sectors. (Relative strength compares the performance of a stock with the performance of all other stocks in the market. A stock with a relative strength of 33, for example, has outperformed 33% of the stocks in the market.)
One of my favorite oil and natural-gas stocks,, has seen its relative strength fall from 93 for the past six months to 77 for the last three months. The fall in strength at Brazilian iron ore miner has been even more extreme: to a relative strength of 52 in the past three months from a relative strength of 95 over the last 12 months.
Gold stocks look even worse., for instance, has a relative strength of 31.
Why are these leadership stocks looking tired? I can think of three reasons:
- First, many stocks in these sectors are facing Wall Street downgrades. Basically, Wall Street analysts are popping numbers into their models and coming up with target prices that are at or below current prices.
On May 21, for example, analysts at Calyon Securities increased their 12-month price target on oil service stockto $88 a share but downgraded the stock to "add" from "buy." Not much point in issuing a buy on a stock that was already selling at $83.28 on May 21. Are you going to rush right out and buy National Oilwell for that potential 5.7% return over the next 12 months?
- Second, inflation has become such a worry that it's hurting these stocks instead of helping them as it did earlier. When inflation climbs but central banks seem to ignore the problem, energy, commodities and other "physical asset" stocks do well. Because these companies own things that go up in price along with inflation, these shares are great hedges against inflation. That's why investors buy them.
But when inflation gets the attention of central banks to such a degree that they start raising interest rates, then it starts to hurt these stocks. (For more on how inflation has become a problem now recognized by central banks across Asia, see my June 13 column.) Actual interest-rate increases slow economic growth, and that's a danger to energy and commodity stocks because slowing growth will cut demand for oil, copper, iron ore, whatever. And less demand will lead to lower commodity prices or at least slower increases in commodity prices than investors have been counting on.
- Third, these stocks have become relatively expensive. Take a look at what's happened to the oil sector. Traditionally, oil stocks trade at a price-to-earnings ratio below that of the average stock in the S&P 500 Index because their revenue and earnings have been so volatile. That's been true even with the sector outperforming the stock market as a whole over the past five years, but the gap has become narrow.