Fundamental Trading Diary

Fundamental analysis of the capital markets

Top-Down Analysis

The shape of the US stock market is very different than it was even three months ago. The financials no longer dominate the landscape like they have for the past decade. Their weighting in the S&P 500 has fallen to 12.9% — down from 23% in 2006.  This is what I was referring to as I wrote on October 12:

Every 5-20 years, the market goes through a tectonic shift as the money invested in companies whose models are no longer as profitable shifts into companies who are.

As I also pointed out then, these cycles seem to be moving much faster as corporate, government and consumer leverage has done nothing but expand.

Here is how it breaks down today:

  1. Technology – 15.1%
  2. Healthcare – 14.9%
  3. Energy – 14%
  4. Consumer Staples – 14%
  5. Financials – 12.9%
  6. Industrials – 10.8%
  7. Consumer Discretionary – 7.6%
  8. Utilities – 4.2%
  9. Telecom – 3.6%
  10. Materials – 3.0%

It’s not very surprising to see consumer staples jump to 14% from just 10.5% in April – the market has most rewarded the safe play stocks.  Also interesting is the ascent of the healthcare sector.  I believe that this sector will only continue to grow in the long-term due to demographics.

Let’s take a look at the major players in each sector.


The dot-com bust marked the seismic change in Microsoft’s core valuation from a dynamic growth stock to a blue-chip value stock.  With a P/E around 10, it’s tough to see Microsoft as anything but a good deal, but even they are not immune to a global recession.  That said, they still have piles of cash, and they will likely benefit from the piles of new government spending which is about to commence around the world.  Most of the new hires will have PCs on their desk, and even the Mac desktops will be running Office.  That said, I still think that the forward earnings estimates are a little optimistic:  it’s expected that they will have earnings growth in 2009 and 2010.  This is not likely to happen in a deep global recession.  When there is blood in the water here — which I suspect there will be at some point — buy MSFT.  Most likely flat for the time being.

Cisco and Oracle are in a similar boat.  They too have been transformed into value blue-chips after a few decades of high flying growth stocks.  I feel that the consensus on Oracle forward earnings is overly optimistic.  They are not immune to global recession either, but they will also benefit from the NND (new new deal) government infrastructure spending.

Apple and Google are likely going through this shift in valuation sentiment right now.  I think they will continue to go through some pain, and I don’t think they make the current estimates for the next two years.

Nokia is a company on the other side of this pattern:  I think they’ve already gone through most of their pain, and the valuation is overly pessimistic at this point.

To summarise the technology outlook, I’m fairly neutral if not a bit bearish.


US Healthcare

US Healthcare

During the last recession, the big players — Johnson & Johnson, Novartis, Pfizer and GlaxoSmithKline — were all able to do very well to manage steady earnings increases.  With the exception of GSK, they also maintained rising stock prices.  The massive, inefficient and extremely profitable health-care industry will only become more so with the introduction to even more government spending in health-care suggested by President-elect Obama, our aging population and burgeoning retiree class of fat boome

From 2000 through the end of 2002, the S&P 500 lost nearly 35%.  XLH lost only 10%.  I think things are setup for an even better result this time around.


With oil prices finally falling from the sky after demand tails from the entrance of a global recession, what happens to the big players will have a large impact on the overall market.  According to Bloomberg, each $1 of oil increases Exxon Mobil’s EPS by $0.11.  Were this the extent of it, Exxon would be approximately 3x more profitable.  Exxon’s business is far more complex than this, and must buy oil in addition to drilling it to refine it into gasoline.  Consequently, the spread between gasoline and oil is also important.  Assuming analysts have already modelled this reasonably accurately, this calls for a 34% decrease in profits for 4Q, and then a further 15% decrease for 2009Q1.  This seems a little bit optimistic:   gasoline and crude prices have fallen about 64% since their peaks.  Some of this can be explained away in hedging and delta-neutral integrated deals, and Exxon — like other cash-rich organisations — will be able to play accounting gains with their earnings.  Let’s, however, look at the last time oil was at $45 in August of 2004;  Exxon mobile was trading at just $45 (it closed at $73.42 today), and the global economic prospects were much more promising.  Will monetary inflation push this up even further?  I doubt it.  As a consequence, I think Exxon is worth a lot closer to $45 than it is to $73.42.  I see similar prospects for the other major integrated energy stocks.

Consumer Staples

Today we witnessed the largest deflation in CPI since the 1940’s.  That said, ex-energy and ex-food, there was actually a 0.1% increase.  With this year’s deep recession and job losses, I doubt the volume of consumption will increase much.  The flight to safety and quality has also given the top companies in this sector a relative premium to its peers:  Proctor & Gamble is now trading at 16.64x earnings.  Non-durable consumer goods is trading at 16.7x earnings, and the non-cyclical consumer goods is trading at 15x as a whole.  I believe, as a consequence, that the safety premium has already been established, and that these companies will get cheaper relative to their earnings as they disappoint.  The only hope for their earnings is that the monetary inflation turns into broader inflation.  I’m non-committal on the fair value as a consequence.


At some point, these institutions will stablise, but not yet.  The glut of ARM resets won’t hit until 2009Q3, and there is still a lot of pain left in the housing market.  That said, $700B on the balance sheet and another $700B increase in almost free lending from the Fed will do a lot to ease that pain.  We don’t know enough about the balance sheets of these companies to know with any degree of certainty what will happen.  This one is a wildcard.

Industrials & Consumer Discretionary

Whatever happens to the automotive industry – whether they get their bailout or not – the shareholders are going to get screwed.  Out of the S&P 500, there aren’t many companies left standing.  The largest ones — Daimler (21B market cap, 4.45x earnings), Nike (21B market cap, 12x earnings) and PACCAR (8.62B market cap, 7.49x earnings) seem to have a pretty hard ceiling.


With the current market conditions, I see another 10-15% in downside, with a particular focus on energy stocks going down.

Sector S&P 500 Weight 6-12 Month Outlook
Technology 15.1% Neutral / Moderately Bearish
Healthcare 14.9% Neutral / Moderately Bullish
Energy 14% Bearish
Consumer Staples 14% Neutral / Moderately Bearish
Financials 12.9% ????
Industrials 10.8% Bearish
Consumer Discretionary 7.6% Bearish

November 20, 2008 - Posted by | Uncategorized

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