Last week, I gave my outlooks for the consumer, energy and financial sectors for 2008. Today, I am going to expand the list to include the rest of the GICS sectors. As a reminder, my own investment process has fairly low turnover with an average holding period of about 2 years for each security and is bottom up in nature, however, in my opinion it is important to understand the underpinnings that are driving sectors over the intermediate term.
Bull Case: The health care sector is a less cyclical sector of the market, and as a result, is less susceptible to potential weakness in the economy during the first half of the year. Valuations in many parts of the sector are relatively attractive. The sector has underperformed the overall market by a significant margin over the past couple of years which could be seen as an argument for a reversion rally. Long-term demographics of an aging population favor long-term strength in the sector. Global purchasing power also continues to increase, and could drive strong global growth going forward.
Bear Case: Political and government uncertainty could result in significant regulatory changes going forward, many of the larger pharmaceutical names are suffering from backlog issues. Spending on more discretionary health care items could decline if the U.S. were to experience a prolonged economic slump. Medicare and Medicaid reimbursements are also highly volatile.
My Take: The health care sector is a large sector within both the large cap and small cap sectors, and offers some compelling opportunities. I am not as positive on the pharmaceutical names in part due to the lack of names in the area in the small cap space, and in part due to many of the backlog issues. Some very attractive opportunities exist in the nursing home and biotech spaces, but valuations and future growth are key to examining the positions.
Bull Case: A large portion of the revenues from industrial companies is generated from overseas sales, and geopolitical risks could allow for continued strength in defense spending. A strengthening U.S. economy in the second half of the year could lead to increased sales in the auto and aerospace industries.
Bear Case: Valuations in the sector are somewhat rich, so if global demand were to slow it would negatively impact performance in the sector. Political uncertainty could lead to changes in defense spending, as well as uncertainty in the auto and aerospace industries.
My Take: Overall, valuations are more expensive then what I typically like to see in this sector, however, there are some very compelling opportunities in the sector, especially in the very smallest cap names where valuations are less expensive. I recently purchased a position in one company in this sector which is available for subscribers. I would expect overall performance in the sector to be relatively neutral to other sectors with a slow start, with improvements occurring in the second half of the year.
Bull Case: Materials prices are near record highs (at least on a nominal basis) which can support the underlying stocks so long as they remain high. Speculation in the sector is, in my opinion, adding a premium to pricing in the sector. Demand remains high across emerging markets which are experiencing very high growth rates, but consumer spending in the U.S. on the very high end of the market is yet to show a significant falloff. Global employment, and prices could still move higher on a dollar basis if the currency continues to selloff in the new year.
Bear Case: Any type of global slowdown will affect overall demand for precious metals or building materials. It is possible that in order to control pollution in China, a building moratorium will go into effect for a limited period of time. The U.S. dollar will begin to climb. Many of the stocks are highly susceptible to price movements in underlying commodities which creates large amounts of volatility. It seems that nearly everyone is positive on this sector (remember the last time we saw this was in the 99-00 period when nearly everyone was bearish: take a look at some of the covers of magazines such as the Economist or Business Week).
My Take: Materials stocks did exceptionally well in 2007 primarily due to very large gains in the prices of many precious metals. Although, the supply/demand dynamics have not changed by a large margin, the sector has experienced a large amount of speculative action, and in my opinion, is due for a correction. My expectations are for a significant correction as fears of a global slowdown materialize for the first half of 2008 followed by some improvement in the mid to late portions of the year. China will also likely have some type of building moratorium during the first half of the year which could negatively impact this sector as the country tries to make their air a bit cleaner prior to the August Olympics in Beijing.
Bull Case: Product cycle upgrades in the sector could lead to increased growth rates throughout the coming year, as valuations outside of some of the leading companies are still relatively attractive. The U.S. economy has very low rates of unemployment, and thus far corporations are continuing to spend to improve productivity and efficiency. Less sensitivity has been shown to housing issues.
Bear Case: It is unclear whether corporate spending will continue to tick up from the improved levels in 2007. The potential exists for increases in unemployment or the slowing of economic growth. Valuations are rich in some of the larger names in the space.
My Take: Overall, I am positive on the technology sector although I feel that valuations are a bit rich among some of the larger firms in the space (Research in Motion (RIMM), Google (NASDAQ:GOOG), Baidu.com, Inc. (NASDAQ:BIDU), etc.). In the small cap area, many technology stocks are trading at relatively compelling valuations and this is an area where I may increase my positions in the sector with any price weakness on a stock-by-stock basis.
Bull Case: Significant international exposure in many of the names could drive growth during the year along with a second half rebound in the U.S. Many of these companies have significant cash flows, and the cost of doing business may decline as global rates decline in the first half of the year.
Bear Case: Valuations are rich in many names as prices of the stocks have done very well recently. Many companies in the sector have a large debt-load, and growth rates may not be sustainable in the sector over the intermediate term.
My Take: Most of the dominant players in this sector lie outside of my investable universe in the large cap space. Overall, based on valuations among the names in my universe, I am slightly bearish on the sector, but like other sectors, compelling opportunities could develop over the course of the year with a price correction on a stock by stock basis.
Bull Case: Dividend yields are very attractive as compared to most other sectors and against many yields in the fixed income market. Industry dynamics have significantly improved over the past several years as demand has rapidly increased. Environmental concerns have also been a key factor in lowering supply, thereby enabling existing utility firms to improve their overall cash flows. High energy prices are a factor in success in this sector.
Bear Case: A cooling of energy prices or lower demand in winter or summer months could hurt demand, and valuation levels are on the upper end of the historic range. Large debt loads, constantly changing regulation, and environmental concerns could erupt in, and have a negative effect a certain segment of the sector.
My Take: Overall, I am neutral on the sector. I like the overall dynamics of the sector with increased demand but am concerned with the valuation levels in the industry. Although, I am neutral on the overall sector, I do own one company in the sector which I still consider to be attractively priced.