In his book "How to Make Money in Stocks," famed investor and
founder of the
Investor's Business Daily
publication William J. O'Neill suggested that the performance of
the sector and industry in which a stock is categorized ultimately
determines one-third of an individual stock's performance. In other
words, just by picking the right industry (or avoiding the wrong
one), an investor is well on the road to solid profits. Since that
statement, some studies have shown that a particular sector's
influence can approach 50% of a stock's overall movement. Either
way, the lesson is clear -- sectors matter.
With this in mind, some clear sector trends have emerged in the
past four quarters that investors should consider as we head into
the new year. I broke out these trends according to market
capitalization , allowing investors to better pinpoint hot and cold
Let's take a closer look at them...
Although the broadmarket was a bit of a disappointment in the third
quarter, with the S&P 500 posting a 3.7% decline in
year-over-year operating profits, there were a couple of bright
spots within the large-cap group. Consumer discretionary stocks,
for instance, solidly grew their third-quarter income, reversing
modest weakness seen in the second quarter, and putting up growth
numbers that other sectors didn't even come close to reporting.
Take the financial sector as an example. The sector posted a 4.7%
decline in year-over-year income, while energy stocks saw income
fall 28% in the same period.
Industrials such as
Raytheon Co. (
L-3 Communications (
deserve an honorable mention, too. While last quarter's near 6%
improvement in year-over-year income isn't huge, these companies
have been quite reliable on theearnings front and are priced
fairly. L-3, for instance, saw 12% year-over-year income growth in
the most recent quarter, and is only priced at 9.1 times its
trailing 12-month profits.
It's not all bargain-basement pricing and red-hot growth for
large caps though.Consumer staples stocks are priced at the extreme
upper end of what the market may view as palatable right now, with
an average price-to-earnings (P/E ) ratio of 15.9.
Basic materials stocks posted pitiful numbers in the third
quarter. Had it been the first time we'd seen weakness from the
sector, it might be dismissible, but the group has been in trouble
for four consecutive quarters. While the sector's forward-looking
P/E ratio of 11.9 seems to already reflect pessimism regarding the
future, deteriorating earnings continue to be red flags.
Gold-mining stocks are hitting a wall, but other miners are also
Titanium Metals (
, for instance,
posted a 38%profit decline in the third-quarter compared with the
same period last year.
E. I. du Pont de Nemours and Co. (
missed estimates by 30.6% last quarter and has actually seen
profits decline by nearly 10% in the past 12 months.
As well as large-cap consumer discretionary stocks have done of
late, the mid-cap stocks in the sector have been even stronger. The
average year-over-year earnings growth from the mid-cap stocks in
this group for the past four quarters is a whopping 31%, making
their slightly-elevated valuations more than worth the price, with
an average trailing P/E ratio of 17 for the group.
Running a close second are the industrial stocks. In fact,
mid-cap industrial stocks have been better performers than their
large-cap counterparts in the past four quarters, averaging a 23.3%
increase in year-over-year income. They're still bargain-priced
too, trading at about 12.4 times their projected 2013 earnings.
On the flipside, telecoms among the mid-cap group have been an
earnings disaster and are way overpriced to boot. Mid-cap energy
stocks have also hit a wall, though at least these stocks are now
priced down to appropriate levels, trading at 12.8 times their
projected 2013 earnings.
Considering the sector was one of the best for the mid-cap and
large-gap groupings, it should come as no real surprise that
small-cap discretionary stocks are among the top performers
relative to theirmarket cap peers. The financials and consumer
staples stocks top the list of strong growers as well. Still,
investors may want to choose individual stocks carefully for all
three groups, since valuations have become frothy (even by
Laggards from the small-cap realm include technology and energy.
Both sectors have seen their small-cap stocks repeatedly post
double-digit declines in year-over-year profits for several
The only other red flag from the small-cap group is health care.
Though these companies have been reliable earners, the average 9.5%
growth pace doesn't quite merit a trailing P/E ratio approaching
20. The forward-looking P/E of 16.3 isn't exactly compelling
Risks to consider:
Although these are long-term trends, it doesn't take a full
year for a tide to turn. Anything can happen in less than a
quarter. Investors should always be cognizant of the fact that even
the biggest of trends can change, sometimes quite abruptly.
Action to Take -->
The next logical step for investors looking to apply this analysis
is simply to consider paring current holdings they may own in the
troubled sectors. Also, it's not that this rotation of stocks
has to happen immediately. After all, it took four quarters for
these trends to become evident. This analysis should simply be the
groundwork for an allocation plan heading into 2013.
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