Titan Investment Partners – Is it time for sector rotation based on valuation?

Global, regional and local economies, despite the best efforts of bankers and politicians, are cyclical in nature, moving periodically from boom to bust and back again. Financial markets, which in their purest sense are a derivative of  those economies, are also cyclical or, to be pedantic, the flows of cash in and out are as investors seek to adjust their portfolios to positions themselves to take advantage of these changing economic currents.

Over time, certain sectors have become associated with certain points or trends within these economic cycles. That is to say that they have different performance characteristics at different points along the inevitable “boom and bust curve“.

For example, as a cycle of economic growth starts to take place, then so demand in an economy  for basic materials such as  metal ores , aggregates , cement etc begins to pick up as these are the building blocks (often quite literally) of production. Further into the cycle, as demand continues to grow, there will be a call on equipment such as machine tools and other capital goods that are necessary to manufacture products the growing economy demands. Finally, in our simplified example, as prosperity within the economy grows and spreads, there will be an increased demand for life’s luxuries / non essentials such as new cars, travel, fashion &  consumer technology etc.

Stocks that are sensitive to these economic trends are described as Cyclicals and furthermore those that service the final stages of the demand cycle are seen identified as being Consumer Discretionary. That is to say that these products and services are non-essential as we can get likely get by without that new Swiss watch! Unlike their peers, Consumer Staples which include necessities such as Food (Retailers and Producers) are deemed to be essentials.

Of course, in the modern world, not all economies move at the same pace and nor are all economies aligned as far as their position in the economic cycle is concerned. For instance developed and emerging economies will often be at different ends of the economic cycle. Indeed, developing economies have historically provided developed economies with raw materials or more latterly cheap manufactured goods. But, their under developed &  less sophisticated  economies may not experience the same mid stage growth/demand cycles that one might associate with a European or North American economy.

Spotting the turning points in economic cycles occupies the minds of economists, analysts, traders and fund managers alike who will all, to varying degrees, be watching economic data for an early insight into economic trends and attempting to position oneself ahead of this and so profit. I think it’s fair to say however that much of that data is easier to interpret with the benefit of hindsight! This creates something of a dichotomy because though changes in economic trends may be easier to spot looking back over historic data that of course is usually too late when it comes to investment in the markets!! Markets are forward looking and tend to run ahead of (or anticipate the data) in an economy, typically by six months or more.

However there are other tools we can use to try and identify the turning points in cycles of demand. One useful method is to look at historical valuations for indices, sectors and stocks during previous economic cycles and compare those to the current situation.

This can be further nuanced by using inflation adjusted data; that is comparing real money rather than nominal figures whose values will likely have inflated over the passage of time. 

This inflation adjusted data known as CAPE ratios IS most closely associated with the American academic Dr Robert Shiller and who, as we write these words (14/10/13) has been awarded a Nobel Prize for Economics.

A recent note by a leading US investment bank suggests that we may now be approaching a pivotal point in the valuation of Cyclical / Consumer Discretionary stocks here in Europe as expectations about future earnings for these sectors are amongst the most optimistic in the markets. Furthermore, the forecasts for EPS and sales growth in these sectors are high versus historical norms and so leaving plenty of room for disappointment as we move further into Q3 earnings season both here and in the USA.

Based on a comparison of  their inflation adjusted PE ratios  sectors  in Europe (including the UK ) that are seen as expensive include Consumer Durables , Commercial Services , Autos and Capital Goods  (the latter two are particularly important as far as export led economies such as Germany  France & Sweden are  concerned). Conversely, those sectors with a low relative inflation adjusted PE include Utilities, Food Retail and Energy (which includes Oil & Gas )

Within the funds we run here at Titan Investment Partners we have several allocations to stocks within the Energy sector which we perceive to be undervalued and  whose prices we feel should rise as capital flows move out of the expensive discretionary sectors mentioned above and into those which are seem to be undervalued. The difference with us and the vast majority of analysts and fund managers is that (a) we have our own money on the table and (b) attempt to anticipate these fund flow moves ahead of the herd rather than in unison with them.

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