Which sectors are past their sell-by date?

Some sectors in the economy have become seriously overvalued, while others offer the prospect of healthy returns.

If we look at the market at a super-sector level, it is obvious that there is a major divergence taking place between the resources sector and the financial and industrial sectors, which means that there are likely to be growing opportunities in the undervalued areas. The table below shows the three main sectors and their p:e ratios and dividend yields.

There is a clear theme in the world economy, resulting from the sub-prime crisis that has been in evidence since the middle of 2007 which is impacting on certain commodity markets. Central banks initiated a range of policy actions in the second quarter of 2007, slashing interest rates and pumping liquidity into the system to restore health to the financial sector and capital markets more broadly. Without hesitation, the speculators pounced on the global low interest rate environment, turning their attention away from the credit markets and towards commodity markets, with the result that prices of hard and soft commodities have scaled new heights in 2008. Moreover, inflows into commodity funds so far this year have already exceeded the flows seen in each of 2003, 2004 and 2005, and almost match the annual figure for 2006.

Although there are good reasons for the commodity markets to be firm, with strong physical demand, prices have leapt into “excessive exuberance” territory, indicative of bubble-type environment. At this stage, perhaps 25%-30% of some commodity prices can be attributed to speculation rather than fundamental demand.

However, when a sector becomes fully priced, it does not mean that the entire sector is stretched. Often, there are only some elements driving the sector upwards, while other parts lag. For example, in the late 1990s, when the telecom, media and technology stocks raced ahead of the market, clearly not all industrial stocks were overvalued. More recently, we have seen the building and construction sector rise to an exotic level, but this again did not mean that all industrial stocks were expensive.

So we need to look at the market in a more comprehensive way. Because the resources index is high at present, we can’t infer that all resources stocks are overvalued.

Some good evidence of this comes from comparing the values of, say pulp and paper counters with those of the mining sectors. Look at the following ratios:

If I had to unpack the super-sectors and look at some of their underlying elements with a view to switching between the sectors, the following themes stand out:

I have always maintained that a wise investor is a patient one. These sectors aren’t necessarily going to take off like a rocket in the near future and they may need a catalyst to spark the turnaround. However, this does indicate where value can be found.

Finally, it goes without saying that stock selection is as important as sector rotation. Once you have found the sectors that are likely to outperform, attention must then turn to a search for quality companies within that sector.