Raymond Micaletti's  Instablog

Congratulations to those who have been on the right side of this market's relentless rally. Regardless of the persistent questions as to whether the recent uptrend has been just another bear market rally or the origins of a sustained bull market, your gains are real.

Now it's time to protect them.

In attempting to explain the logic behind the market's rally, we wrote on April 20th:

In other words, the market, with a fairly stunning degree of underlying structure, has essentially reset itself to its pre-Geithner-bank-plan... level. In light of the marginally less dire circumstances investors perceive the world to be in, this strikes us as completely reasonable—even if it required that some stocks exhibit triple-digit returns during this rally in order to reclaim their pre-selloff levels. Which is another way of saying the prior selloff was most likely overdone. In resetting itself to pre-selloff levels, the market has thus borne out the logic: if things are seemingly less bad now than they were prior to the selloff, the market should be at, around, or slightly higher than its pre-selloff level.

The pre-selloff level for the S&P 500 was 870 (as of February 9th). On Friday the index closed at 929--7% higher than its February 9th level. The "underlying structure" we were referring to was that the stocks that had been beaten down the most (least) during the February-to-early-March selloff have been the ones that have risen the most (least) in the ensuing rally. Despite the reasonableness of the rally in the aggregate, however, it may now be time to reassess the prospective appreciation potential of the rally leaders relative to the rally laggards.

In particular, the time may be ripe for investors to rotate out of the sectors that have led this rally--most notably Financials and Consumer Discretionary--and into the sectors that have lagged, namely, Consumer Staples, Utilities, Health Care, and even Energy. If one prefers not to take directional risk, however, one might instead express this rotation by going long the laggard sectors and going short the S&P 500 as a hedge (or, if one is brave enough, going short the Financials and Consumer Discretionary sectors outright).

Why might the time be ripe to lighten up on the rally winners and to accumulate the rally losers? Several reasons. Consider the following:

• From the March low to Friday's close the S&P 500 Financials Index has returned 115%. Clearly, the current pace of gains (8360% on an annualized basis) is unsustainable. Moreover, the index is now 32% higher than it was prior to the panic-induced February selloff, and only 25% below it's pre-Lehman-bankruptcy levels.
• The two largest stocks in the S&P 500 Financials Index, JPMorgan and Wells Fargo, are now trading at virtually the same levels they were trading at--on average--prior to the onset of the credit crisis in August 2007. That is, JPMorgan's average price from January 2004 until August 2007 was 41, while Wells Fargo's was 32. On Friday, JPMorgan closed at 39 and Wells Fargo closed at 28. Not to be outdone, Goldman Sachs is now trading higher than its average level prior to the credit crisis. On Friday, Goldman closed at 139, while its 3-year average price prior to the credit crisis was 137.
• 26 out of 80 constituents of the S&P 500 Financials Index are now trading within 20% of their pre-credit-crisis average prices; an additional 24 out of 80 are within 50% of their pre-crisis average levels.

Clearly, the market for Financials is implying economic recovery and an earnings rebound, yet the jury is still out on whether the banks' first quarter earnings will be sustainable--and if the earnings are not sustainable, the price of the index may be reflecting overly optimistic expectations. Keep in mind that:

• Losses on commercial real estate and credit card portfolios are most likely coming down the pike sometime in the next twelve months (as well as additional losses on residential mortgages).
• First quarter earnings may have been turbo-charged by, among other things, changes in mark-to-market accounting and lower set-asides to cover future losses, not to mention one-time trading gains thank to AIG's unwinding of its portfolio to its own detriment and to the extreme benefit of its trading partners.
• Certain parameters of the stress test's "adverse scenario" have already been actualized--namely, the 2009 unemployment rate and the deliquency rate for prime loans.
• The Wall Street Journal reported that several banks strenuously opposed the government's initial loss projections and capital requirements, and ultimately won concessions from the government--such behind-the-scenes wrangling calls into question the credibility of the stress tests.
• Several banks may have to raise equity capital, which will dilute current shareholders.

Therefore, in light of the ongoing risks that Financials face and given their recent meteoric rise, one could hardly be faulted for lightening up positions in the sector. Of course, for technical reasons financial stocks may very well have some short-term upside remaining--the 200-day moving average is only 3% away and the December 8th intraday high is only 4% away. Moreover, one should be aware that if Bank of America were to reprice dramatically higher, the sector could move up non-trivially, on account of Bank of America's disproportionate weight in the sector.

A similar story prevails for Consumer Discretionary stocks. The sector has risen 50% from its lows and is now 20% higher than it was immediately prior to the February selloff. The sector is trading at 31x trailing earnings and 42x forward earnings. In the last 15 years, the sector's highest P/E multiple on trailing earnings has been 32 (in March 2002), so we're knocking on the door of that extreme.

But given the ongoing unemployment story, the continued deleveraging of the consumer, and the potential persistence of the increased savings rate, this sector may have gotten a little bit ahead of itself as well. It's only about 20% below its 3-year moving average prior to the onset of the current bear market, yet its earnings are down well over 50% from their peak and are estimated to decrease even further. While it's certainly not unusual for markets to rise before earnings do, the enormous price appreciation in Consumer Discretionary names may be a huge leap of faith by the market with respect to the likely future behavior of the consumer. (One notable data point that stood out to us: Between February 9th and April 20th, earnings estimates for Sears Holdings Corp were lowered by 36%, yet the stock rallied 55% over that period.)

(Of course, if what we've witnessed has been a bear market rally--driven mainly by short-covering of low-priced, low-quality stocks--the price action in the Consumer Discretionary sector becomes a lot more understandable. But let's give this rally the benefit of the doubt.)

Bottom line: The market is implying that an earnings rebound is on the way for Financials and Consumer Discretionary stocks. Even if such a rebound is coming, however, these stocks have almost certainly priced it in. And given the non-trivial risks still facing these sectors, it may be prudent to cut one's exposure to these sectors soon while the getting out is good.

In contrast, several other sectors have basically been wallflowers during the course of this rally, despite having (on the surface) compelling valuations and robust earnings. To wit:

• Consumer Staples stocks bottomed at 11x earnings in early March and are now trading at 13x earnings--earnings that are close to peak levels. Over the last twenty years, Consumer Staples stocks have had an average P/E ratio of 20. While an average multiple of 20 might seem high, Staples' earnings have increased (virtually) monotonically over the last twenty years with low volatility (which is why investors have been, on average, willing to pay 20x for these earnings).
• Similarly, Health Care stocks are trading at 10x earnings--earnings that are at peak levels. As with Consumer Staples earnings, Health Care earnings have grown monotonically, and their 20-year average P/E has been 23. While it's true that Health Care stocks may be facing headwinds from President Obama's stated plans for the health care industry, are these prospective plans worthy of causing a 60% discount in Health Care stocks from their historical average valuation level?
• Utilities stocks are trading at 11x earnings versus a historical average of 15x. As with Consumer Staples and Health Care earnings, Utilities earnings are near peak levels. In addition, Utilities stocks in the S&P 500 are 10% lower than they were on February 9th, despite the fact that one rationale for this rally is that things are seemingly less bad now than they were in early February, and therefore stocks should be priced accordingly. Have things gotten worse for Utilities now that the economy appears to be on the verge of recovery? (If not, then this peculiarity may be the "tell" that, indeed, this has been a short-covering rally driven by the unwinding of quant funds and exacerbated by fast-money operators continually seeking out the double-digit returns du jour and piling in to make it all self-fulfilling.)
• Energy stocks have only recently started to gain traction in this rally (since the beginning of May), but have only recovered to their February 9th level (while the S&P 500 is 7% above its February 9th level)--despite the fact that oil is now pushing $60. Unlike the earnings for Staples, Health Care, and Utilities, however, Energy sector earnings have come down a moderate amount (though much less so than the earnings of Discretionary and Financials), so the fact that they lagged the rally is not a huge divergence. But again if the rally is based on economic recovery and not on the purely technical events of short-covering and momentum-chasing, one would expect Energy stocks (along with commodities) to do well. Commodities have, in fact, done well, as have Materials stocks, yet Energy stocks have not participated to the degree that one might expect (though, as mentioned, over the last two weeks this has begun to change).

While we wouldn't rule out sector-specific risks as the reasons for why the aforementioned sectors have lagged during this rally, the most likely explanation is that these sectors lagged the rally simply because they didn't fall as much during the selloff. Nevertheless, given the current state of this rally and its resultant relative valuation landscape, and in light of the ongoing economic risks, we think the following conclusions hold:

1. If this rally has truly been based on the omniscient market's ability to foresee a brighter economic future, it certainly makes sense that Cyclicals, Financials, and the most-beaten-down stocks would have benefited the most during the initial rebound. At the present time, however, both Consumer Discretionary and Financials stocks are pricing in dramatic earnings rebounds--rebounds that may or may not materialize. Given the continued uncertainty in these sectors coupled with their rather generous valuations, if an economic recovery is indeed on the way, why not invest in sectors where earnings have not skipped a beat, and where stocks are trading 30-50% below average historical valuations (i.e., the laggard sectors). Such stocks should benefit both from earnings growth and from multiple expansion (and we haven't even touched upon their relatively substantial dividend yields).
2. On the other hand, if this rally has been based on short-covering and momentum-chasing (technical events that could easily explain the topology of returns that we have witnessed over the course of this rally) rather than on fundamental demand, once the technical buying and its attendant euphoria (or panic, if one is short) fade away, the leading sectors could very well drop just as quickly as they rose. Here again, one is led to the conclusion that the sectors that have lagged during this rally should begin to outperform--regardless of the overall direction of the market--on account of their robust earnings and relatively attractive valuations.

Of course, in the short-term (two weeks to two months) we're fully prepared to see Financials and Consumer Discretionary stocks rocket higher. That's just the nature of the beast (particularly when "important" technical levels are in sight and options are about to expire).

But at some point economic reality will set in and investors will realize that either a) the rally leaders are fairly valued and the rally laggards are undervalued or b) the rally leaders are overvalued and the rally laggards are fairly valued. In either case, over time we would expect a valuation convergence, whereby the rally laggards subsequently outperform the rally leaders, regardless of the future direction of the overall market. 

Disclosure: The author has long positions in DIG, FAZ, SDS, and EEV. Positions are short-term and likely to change intraday.