A Tale of Two Sectors: It Was the Best of Buys, It Was the Worst of Buys*

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The S&P 500 is up over 15% Year to Date (YTD), but the gains have not been evenly spread between sectors. Of course, if you own a broadly diversified portfolio of stocks that never changes, or an index tracking fund, this doesn’t concern you. If, however, you are one of the growing band of investors who prefers to have a little control over your money, then it poses an interesting dilemma. It is an age old problem, should you follow momentum or be somewhat contrarian? Should you hold onto the year’s top performers or rotate into something with more upside? There is no one correct answer; each case must be evaluated on its merits. This is amply demonstrated by looking at the top two performing sectors of 2013.


Table from Standardandpoors.com/indices

As you can see, Health Care and Financials have been leading the way this year, both up over 20%. I would maintain, however, that while one of these leaders is set to continue outperforming, it may be time to take some profit on the other.

Let’s start with the positive. Until this year, the financial sector was a bystander as the market recovered. Lingering problems with mortgage and loan portfolios made investors wary and kept both profits and forecasts depressed. At a time when many companies were returning value to shareholders in the form of increased dividends and share buybacks, the banks were forced to shore up their balance sheets. They were generating cash flow, but stockholders weren’t benefitting in the short term. Just as importantly, distrust in the sector remained strong. Stories such as the London Whale and the LIBOR fixing scandal suggested that major financial institutions had learnt nothing from the events of 2008-9. Conventional wisdom was that they were still displaying the same old arrogance and addiction to excessive risk. As the gradual economic recovery continued it became inevitable that at some point the financial sector would begin to catch up. That has happened this year. The YTD numbers are impressive, but over 1 year the rise has been even more spectacular, with financials up around 42%, or nearly twice the gains of the broader market. It is tempting to say, after such a move up, that a correction is inevitable, but I don’t believe so.

Government programs and a commitment to low interest rates by the Fed have begun to have an effect on the housing market. The resultant green shoots of recovery in housing prices have made clearing the backlog of repossessions seem less daunting than it did a year ago. US banks’ capital to asset ratios have climbed consistently since the recession, reaching 11.3% in 2012, according to World Bank figures. In other words, the sector is better positioned to handle a crisis than at any time in recent history. As a result, regulators are gradually allowing the sector to begin to return dividends to normal levels. The distrust is, to some extent still there, but the relatively small dent in the profitability of JP Morgan (JPM) made by the London Whale affair could well be taken as a sign that things have indeed changed. Major US banks are more resilient and better equipped to deal with the calamities that come with a business based on risk. It would seem that conditions for the financial sector continue to improve; stock prices should do the same.

The other big winner this year, Health Care, is a different story. On the surface it would seem that the inexorable rise in the sector will continue forever. With an increasingly ageing population and new treatments and technologies to offer to that population, it could be argued that the expansion in Health Care has only just begun. This is all true, but there is a limit to how long that expansion can continue. Again, according to The World Bank, US healthcare expenditure accounted for 17.9% of GDP in 2011. Logic tells us that the growth in that number must be limited. To me, there are two factors that would seem to indicate that we are approaching that limit.

Firstly, Obamacare; I have no wish to delve into the minefield of healthcare politics, but the fact that Congress passed healthcare reform at all after decades of trying indicates an increasing awareness that something must be done to control costs. What that something will be is an argument for the politicians, but exponential growth in the sector will be curtailed in some way. Secondly, the industry itself seems to be worrying about future growth. In the State where I live, we have been treated to an advertising campaign in which hospitals highlight the good that they do, and plead for support in ensuring their survival. Given the recent revelations about pricing by hospitals and the frequency of high six and seven figure salaries among hospital administrators this is a little surprising. Again, I will leave the politics aside, but if the industry is worried enough about the future to launch a PR campaign, then I am worried too.

Both the Health Care and Financial sectors have been stellar performers so far in 2013. At first glance, it would seem that Health Care must continue to rise, while the inherently more risky Financial sector is on shaky ground. Digging a little deeper, however, leads me to the conclusion that they will head in the opposite directions, at least in relative terms, in the coming months.

 

*I apologize for the title and sub-title. My only defense is that I am English, and therefore bred with an inherent disability to resist a pun, no matter how groan inducing it may be.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: News Headlines , US Markets , Economy , International

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Martin Tillier


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