Using Sector Weight Analysis to Identify the Next Bubble

There’s nothing like a bubble to make the markets really exciting. You can make a lot of money in bubbles…if you get out in time (emphasis on the “if”).

It’s not very easy because it's easy to get caught up in the euphoria of a peak, and miss all of the warning signs. It’s easy to give back all your gains at the end of it all.

There is a way, however to tell when a bubble is forming, which sector it’s forming in, and when it will soon be time to get out. In this article, we’ll take a quick look at how they form, where the next one is forming (The end of the bubble era, as many predict, is not), and look at one screaming indicator - 'the end is nearing and to get prepared.'

Anatomy of a Bubble

Bubbles start out innocently enough, and usually start with a simple story. You know…something everyone can understand. A base begins to form, shares in the sector start to move up a bit compared to the rest of the market and there’s some institutional buying. This all happens when almost no one is watching. But, all of that changes during the next stage - when the idea becomes tangible.

This is the key point of a bull market turning into a bubble. It’s when the idea really hits home for the average investor. In the case of the energy bubble, it was the point when gasoline passed $2 a gallon at the pump. In the dot-com bubble, it was when the average investor started trading stocks online, buying stuff from Amazon.com (AMZN), and setting up their first e-mail accounts. It’s tangible, they can see it, and it impacts their daily lives. It’s right in front of them.

Then the run-up continues to the cocktail party stage. This is the euphoric point. By this time, everyone knows about it and everyone is heavily invested. A lot of people are making a killing on shares of companies that don’t make any sense at all. It’s when you have “idea-stage” companies generating $100 million or greater valuations.

It’s a great time, but it’s also the most dangerous time. By this point, most investors have been lulled to sleep. The story is ingrained in our minds and we have a tendency to forget the old adage: “Stocks go up stairs and down an elevator.”

Just take a look at agriculture stocks back in 2006 (This is one that is still fresh in all our minds).

Is It Ever Different This Time?

Oil prices were setting 25-year highs, alternative energy was the hot sector, and ethanol was the solution. The mainstream media was trying to peg how high oil and gasoline prices would go. Practically everyone was focused on the daily ups and downs of oil prices and how much more oil would be needed to feed booming emerging markets at the time.

Meanwhile, some smart money was starting to collect many different agriculture plays. Fertilizer stocks had quietly doubled in the past 12 months and corn, wheat, and soybean prices started to move up too. Still, no one was watching.

Throughout 2007 that all started to change. High agriculture prices started to have an impact on the public. Prices for bread, wheat, and meat continued to increase. A $100 in groceries last year now cost $130. All of a sudden, the unfolding agriculture story was tangible.

In all of those “Top Stocks for 2008” columns in mainstream media featured once-unknown stocks like Terra Industries (NYSE: TRA) and Potash Corp of Saskatchewan (NYSE: POT). How many people even knew where Saskatchewan is? It didn’t matter. “It was never coming to an end” and “you better get in now or else you’ll never be able to get in.” Or, my personal favorite, “It is different this time.”

It took three years for these stocks to walk up steps to gains of 500% to 1,000% or more. But it only took six months to ride back down the elevator. A few years of gains was wiped away in a matter of months.

Throwing Their Weight Around

These ups and downs can be painful if you ride them out. The stock market is highly cyclical. By paying close attention to the cycles, you get in early and get out before it’s too late. The cycles allow you to make an absolute fortune.

The key thing of course is how to identify the cycles. Here’s one way.

One of the best indicators I’ve found for these long-running, wealth-multiplying cycles is the sector weightings of the S&P 500. The S&P 500 is made up of the largest companies on the U.S. exchanges. It contains everything from ExxonMobil (XOM) to Bank of America (BAC) and everything in-between. It covers all sectors, but here’s the thing - catching the right sector at the right time can pay off big. Of course, it takes a bit of analysis and a contrarian style to do it.

The table below shows the different sector weightings of the S&P 500 stocks.

click to enlarge

If you look closely, you can see where optimism is too high and pessimism is too low for different sectors. The energy sector is the perfect example.

In 1980, at the height of the oil and commodities boom, energy sector stocks made up 25% of the S&P 500’s total value. At the time, oil prices were setting new highs and investors were flocking to oil stocks. They bid energy stocks up to the point where they made up one quarter of the entire S&P 500.

In hindsight, energy stocks had reached an unsustainably high level. Energy stocks are valuable (during “normal” periods make up between 10% and 15% of the S&P 500’s value) but they’re hardly worth so much relative to every other company. A decline was inevitable. Then in 2000, when oil prices were bottoming out, energy stocks made up a paltry 6% of the S&P. This time, it was an unsustainable low. Now the energy sector makes up about 13.4% of the S&P 500 – right near the long-run average.

That’s why I’m encouraging everyone to look away from the energy sector. It’s in the middle right now. The energy sector could go up or down from here. Energy stocks going up – as we’ve seen – are hardly a sure thing.

The same is true for the financial sector. Financial services made up a lowly 6% of the S&P 500 in 1980. After two decades of across-the-board double-digit earnings growth (which we are now seeing how they made those earnings) they formed kind of a “silent bubble.” Now, it has burst and financial sector stocks, as a percentage of the S&P 500, are working its way back to historical norms.

Then there are tech stocks. During the height of the tech bubble in 2000, the technology sector made up 30% of the S&P 500. Unsustainable.

Riding the Waves

Looking back it’s seems so obvious. It always does. If you use the table to look forward, it can be quite helpful. There are some waves forming and, if you focus on them over the next few years, you should be sitting pretty at the end of it all.

For instance, the healthcare sector has showed consistent strength relative to other sectors. Healthcare sector stocks have steadily increased from 5.61% in 1980 to 14%, today.

click to enlarge

Right now, I believe we’re still in the early stages of a very long bull market for healthcare sector stocks. The way the trend has been going, healthcare really will likely get booming in the next couple of years.

All of the fundamentals are there - aging population, more resources devoted to healthcare, technological innovation (i.e. genomics, robotic surgery, and stem cells). As these technologies make their way into the mainstream, they will become more tangible. Tangibility in the medical sector is when you know someone who was helped by one of these.

A big run for healthcare is coming. IF this long-term rising trend holds (very similar to the 30-year growth in the financial services sector) the healthcare sector will be one of the best places to have your money for years to come.

You should be able to pick out more than just a growing trend from the table though. There are also a few “unsustainable lows.”

click to enlarge

For instance, the basic materials sector has plummeted in value relative to its relative value for the past 30 years. At 3.1% of the S&P 500, the materials sector is right near 30-year relative lows. It’s the extreme type of situation we’re always looking for. This, just like every other time the sector weightings reach extremes, won’t last forever. As a result, it could be time to start looking at the chemicals companies like DuPont (NYSE: DD) and companies which excel at the basics, like Air Products (NYSE: APD) and Praxair (NYSE: PX) as potential places to sock away your “safe money.”

Also, telecoms have fallen quite a bit and are resting near lows. The utilities sector, although not at unsustainable lows like in 2000, is also also out of favor.

It’s All Relative

There is one key consideration here. You have to remember these are all relative numbers since they are a percentage of the S&P 500. For instance, the utility sector increased from 2.36% in 2000 to 3.9%, today. That's good for a 65% increase and not bad until you compare it to the overall return of the S&P 500. The index is down 41% from the start of 2000 so it offsets all the gains.

Sector weight analysis is not a perfect timing strategy for short-term movements (nothing is). However, it can identify the big long run opportunities long before anyone else is talking about them (think stodgy “old economy” utilities in the heyday of the tech bubble).

This is just one strategy I use to generate investment ideas from the top down. It also serves as a reminder, never to get too caught up in any story. Peak oil, alternative energy, agriculture, the Internet…they’ve all had great stories and strong fundamentals behind them when they first got started. Eventually though, they just get too big.

All sectors reach that point when it’s “get in now, or you’ll never get in,” which never lasts. For now, remember it’s a buyer’s market. For stocks, you’re looking at, set a price and wait for it to come to you.

If these tables show us anything, it’s that the market is cyclical and these sectors take years to play out. With that in mind, I still foresee the medical sector being one of the best places to have your money for the next ten years.

As for the markets, there’s hardly ever any need to rush out and buy stocks. In a market like this, the window to get in on the ground floor will be open for a while. On the positive side of things, good things come to those who wait…and to those who “weight.”

Disclosure: None

Comments

[Stez:]

Thanks

Interesting article and something well worth monitoring as time goes by.
I think updates for weighting would be appreciated.

In a previous article you were hopeful for fertilizer stocks right now very tricky to predict how they will react. Corn prices are weak. Any thoughts?

All the best


Stez

Jan 13 09:34 AM

[MarvinMBA:]

I agree with the author...health care is where its going to be. Developmental companies like DOR and NNVC will be future winners.
You heard it here first...MarvinMBA

Jan 13 10:51 AM

[Roger Knights:]

"good things come to those who wait…and to those who “weight.”"

Clever!

Jan 13 12:00 PM

[Financial A...:]

Good article. It's nice to see ideas about opportunity during these gloomy times.

I must say, I find it hard to believe that basic materials have fallen throughout these past 5 years. That would seem ripe for a pullback, if not an outright boom, after the economy rights itself. Well done.

Jan 13 09:43 PM

[peachberry_tea:]

siegel said something very similar about identifying bubbles - look at the market cap of all companies in a sector. if the value of the entire sector is growing too quickly then it's a bubble. agree with author on this much

but to say that energy isn't going to go up because it's close to its "long run average" % of the S&P is suspicious though.. because the weightings of sectors on the S&P/market changes over time.. and if you make the fundamental argument that over the long run the global economy is booming (and 2008 is just a hiccup) then it makes sense that materials and energy sectors will grow relative to the sectors on the S&P.. and therefore if these sectors are to grow then their weighing should also increase above and beyond the "long run average"

Jan 14 10:53 AM

[camy:]

Gr8 article. Where can i find "sector weightings of the S&P 500" info on the web ?

Jan 14 12:18 PM

[Urbane Gori...:]

Very nice presentation... Well worth considering... jegan

Jan 15 12:35 AM

[sabre_jenn:]

Suggesting that an aging population is going to need more healthcare is hardly news. It wasn't much of a revelation 5 years ago never mind today.

Feb 17 07:26 PM

[jammur:]

Is the healthcare sector still the place to be if the government comes in and prevents most firms from making a profit by forcing them to accept an ~18% to 27% government payment as "paid in full"? The need for healthcare will no doubt increase, but will the profits be there to justify the investment? I do not know the answer, but it would be useful to see what has happened to other healthcare stocks based in Europe/Canada to see the impact of nationalized healthcare on their profits. You must be careful though, if an international pharmaceutical co. based in Europe is making most of it's profits from sales in the U.S., then obviously those profits could shrink. You would almost want to focus country by country....if that data were available.

Jun 16 05:53 AM