Bullish On Financials And Healthcare

by: Alex Gurvich

Last month was certainly a good month for equity investors. The S&P 500 was up 4.95%, for a cumulative 18.20% Year-to-Date return. Volatility was down over 20% to 13.45. We had six sectors outperforming the S&P index, while three sectors underperformed the S&P index.

Month to Date, from July 1, 2013 to July 31, 2013
Sector Ticker Return Return over S&P Volatility Beta Correlation to S&P
Healthcare XLV 7.16% 2.22% 2.5% 0.92 74.1%
Industrials XLI 5.91% 0.96% 3.5% 1.39 80.5%
Materials XLB 5.55% 0.61% 3.1% 1.10 71.1%
Financials XLF 5.35% 0.40% 3.1% 1.29 84.4%
Discretionary XLY 5.27% 0.32% 2.4% 1.03 86.8%
Energy XLE 5.26% 0.32% 3.2% 1.19 74.5%
Staples XLP 4.34% -0.61% 2.4% 0.96 82.6%
Utilities XLU 4.33% -0.61% 3.9% 0.81 42.4%
Technology XLK 3.73% -1.22% 2.8% 0.60 42.9%
Average 5.21% 3.0% 1.03 71.1%
Sector dispersion 3.44%
S&P 500 S&P 4.95% 0.00% 2.0% 1.00 100.0%
Volatility VIX -20.23% 13.45

In this bull market it seems that anything cyclical will outperform and anything defensive will underperform, or does it. If you look closely, five of the six cyclical sectors (Industrials, Materials, Financials, Discretionary, Energy) outperformed the market, but the Technology sector underperformed. Now if you look at the defensive sectors, two of the three defensive sectors (Staples, Utilities,) underperformed the market, but the Healthcare sector outperformed the market. Is the market trading based purely on binary safety or growth trigger (or as some say "risk on risk off") or is the market finally going back to fundamental valuations?

It is pretty safe to say that for the past couple of years stock pickers and investors who base their investment decisions on fundamental valuations have underperformed. The recent market run up is directly attributable to the Fed's "quantitative easing" policies that have inflated asset prices. It is too early to tell if the stock market a leading indicator of the recovering economy or is it just on artificially injected performance enhancing drugs.

To try to answer these questions, let's take the two "exceptions" (Healthcare and Technology) under the microscope and see. As a fundamental investor, it is actually good to see that these two "exceptions" are defying the "risk on risk off" market approach and are actually trading based on their fundamental valuations.

The Healthcare sector (NYSEARCA:XLV) is benefiting from new and profitable drugs coming on the market as well as increasing spending on healthcare. Whether the Affordable Care Act ("ObamaCare") is fully online or not, the healthcare companies are benefiting from growing revenues and profitability. On the opposite side of the spectrum, the Technology sector (NYSEARCA:XLK) is suffering from lower spending and decreasing computer sales and although the sales of other technology products are growing, they are not enough to compensate for lower computer sales, because of increasing market competition and lower profits on the new technology products.

Other sectors that we believe are being traded based on fundamental valuations and not on the risk on risk off approach are Industrials, Financials and Discretionary sectors. The Industrials sector (NYSEARCA:XLI) is beginning to benefit from, although sluggish, but growing, economic recovery. The Financials sector (NYSEARCA:XLF) has better-than-average profitability because of the very low interest environment, where financial institutions benefit from low money cost. The Discretionary sector (NYSEARCA:XLY) is on the rise due to increased consumer confidence that leads to increased consumer spending.

If you look at the year-to-date returns and individual sector excess return over the S&P 500 index (i.e. difference between sector return and index return), the fundamental valuation trends are confirmed.

Year to Date, from January 2, 2013 to July 31, 2013
Sector Ticker Return Return over S&P Volatility Beta Correlation to S&P
Healthcare XLV 29.07% 10.87% 9.5% 0.90 84.4%
Financials XLF 25.94% 7.74% 11.4% 1.19 93.3%
Discretionary XLY 25.92% 7.72% 9.8% 1.01 92.2%
Industrials XLI 20.30% 2.10% 10.5% 1.08 91.7%
Staples XLP 19.97% 1.77% 9.1% 0.83 81.8%
Energy XLE 16.48% -1.72% 12.0% 1.15 85.6%
Utilities XLU 14.56% -3.64% 9.4% 0.73 68.7%
Technology XLK 10.98% -7.22% 9.5% 0.91 84.7%
Materials XLB 9.11% -9.09% 11.7% 1.14 86.3%
Average 19.15% 10.3% 0.99 85.4%
Sector dispersion 19.96%
S&P 500 S&P 18.20% 0.00% 8.9% 1.00 100.0%

We are fundamental investors, so it is comforting to see that the effect of "quantitative easing" on the valuations is tapering off and we are moving, albeit slowly, toward a more rational, fundamentally valued market.

Disclosure: I am long XLF, XLV, XLI, XLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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