Sea Change

MARTIN SOSNOFF IS AN OLD HAND AT the investing game. He published a book in 1975 called Humble on Wall Street, a sort of punchy memoir recounting the sanity-trying stock market of the five years or so preceding the book’s publication.

He had a lot of success managing money in the happy market before things turned ugly in 1973-74. “Stocks we had went from 10 times earnings to six times earnings,” Sosnoff reflects. “There I was, Ahab, tangled in my own harpoon whale lines and being carried down to the depths by the malevolent great white whale. Of what did it avail that all my earnings projections were uncannily accurate? We were buried just the same.”

All of which is to say there is nothing quite like the right stock at the right time. One interesting guidepost to look at is the longer-term market cycles of what’s in fashion and what’s not.

Which brings me to one of my favorite charts. It is a conceptual portrait of market history — stretching back to 1977. Take a look at “The Tree Rings of Markets Past.” This chart marks off the booms and busts of various sectors. You see fat eras of plenty, bulging like swollen rivers after a rain, and you see thin areas of hardship, like parched desert sands:

It shows you the market capitalization share of the S&P 500 by sector. The S&P 500 Index, a popular stock market index made up of 500 stocks, is broken down into 10 sectors, as you can see. Market capitalization is the value of the sector in the marketplace. As stocks rise, market caps swell.

Looking at the chart, you can see what’s been popular. In 1980, the energy sector was hot and grew to represent nearly one-third of the S&P 500. It collapsed thereafter, and energy sector investors took a beating.

In the 2000 bubble, you can see how technology stocks came to represent an even greater share of the stock market, nearly 35%. I’m sure I don’t need to recall how badly mauled investors in technology were as the bubble popped.

The folks who make the S&P 500 Index are always adding and subtracting names from it, so it’s not a true representation of what these sectors did. But the Index still manages to capture the spirit of the past rather well.

I love this chart for all that perspective it gives in one glance. And because it shows how great tides shift in the market. Now unfolding is another great shift.

You can see how financials have come to represent a sizable piece of the S&P 500. Today, they make up over 21% of the whole. Financials have enjoyed a long stretch of prosperity. If the past is any guide, you want to avoid the dominant sector.

Even if you didn’t know anything about the market’s tree rings, you’d want to avoid most financials now. With cracks in the mortgage business giving way, the financials are under significant pressure for the first time in a while.

As John Hussman of Hussman Funds shows, financial stocks have many marks against them, generally speaking. Bank reserves against loan losses sit at a 32-year low. Yet overall net charge-offs are up 50% from a year ago. “Given the thin coverage of the banking system for such losses, rising charge-offs and loan loss reserves are likely to bite deeply into earnings,” writes Hussman.

Historically, the best time to buy financial stocks is when the group trades for about book value. Yes, as Hussman point out: “Currently, the typical multiples are two and often three times that level.” Most financials, he says, “are only ‘cheap’ based on comparisons with very recent norms and on the assumption that the high profitability levels of recent years will be sustained indefinitely.”

But let’s get back to that chart for a minute…

The energy sector — even after taking a much larger part of the pie — is far from danger levels. As recently as July 2004, energy was sitting there at only six and change. It has expanded since by a sizable margin. Yet even today, it’s less than 10% of the S&P 500 — far from bubble levels.

If avoiding the fattest sectors proved helpful, then perhaps giving the skinny sectors a good look might be a good idea. In that vein, note the squeezing of basic materials so tightly it barely registers on the chart.

What is the basic materials sector? It’s all the companies that do the dirty work and bring up metals like copper, nickel and zinc. It’s all the stuff that we need to build pipelines and power grids and more.

Nothing lasts forever. Things won’t always stay bad and can’t possibly stay good. This is some of the most elementary investment thinking but is painfully true. If you can keep an open mind and remain patient, the goldmine you missed years ago may be right in front of your face before you know it.

Sincerely,
Chris Mayer

December 5, 2007