Over the last four years, the market has been led by substantial moves within a few key sectors. In ...
Over the last four years, the market has been led by substantial moves within a few key sectors. In 1997, for example, the bank sector outperformed the wider market by 20% on the back of the demutualisation of the former building societies. In 1998 and 1999, and the early part of 2000, technology sectors led the way posting exceptional returns. Since then, however, interest has reverted to those areas of the market that were previously out of favour, such as pharmaceuticals, where the apparent visibility of the earnings stream afforded obvious benefits.
At the start of 2001 therefore, it is not surprising that investors might want to pick new themes and sectors to favour or avoid. A word of warning however. In hindsight, it is clear that many of the extreme sector movements over the last few years were driven more by technical distortions within the market than underlying fundamentals within the sectors. Clearly it was impossible for institutions to gain an equity holding in the building societies before or, for many, immediately after they were floated given the dominance of private investors. As a consequence investors chased existing bank shares higher to gain a proxy position.
The same issues were clearly at play during the remarkable rise in TMT stocks. Some of the existing constituents in these sectors and many of the new flotations had restricted free floats, that is to say only a small percentage of the company's shares were available to investors generally, the rest held by founding shareholders, directors or family. With index fund managers and their closet brethren accounting for roughly 25-30% of the domestic market, share prices were pushed higher as investors fell over themselves to gain a foothold.
Thankfully most of the major global indices have since moved to weight inclusion in their series by free float rather than by market capitalisation. This not only makes distortions less likely but also helps active fund managers. Index funds performed best relative to active funds when new issues surged in areas where existing market exposure was limited. This will no doubt happen again but the free float rules should limit the impact.
If investors conclude that such extreme sector movements are unlikely to be repeated, it is sensible to assume that the market will revert once more to being stockpickers.
Just as the bull market in technology stocks started out rationally with investors selectively favouring the better growth opportunities, only to be replaced by an irrational tide of enthusiasm for anything that moved in the area, so the bear market has seen fund managers proclaim a more stock-selective strategy. UK fund managers still seem to be in love with technology stocks, always hoping for a sustainable rally, but this has not stopped them avoiding the more obviously flawed companies and focusing instead on the quality plays.
Although a stockpicking strategy is likely to be far more rewarding than a sector strategy, a view on the later is still useful. The risks, particularly in the US, lie with the rapid slowdown in business investment that has been a key driver of final demand. Happily, by accident or design, most of the major Western economies have put in place tax cuts and/or government spending increases that should bolster consumer demand. With this in mind then, what are the sector opportunities?
First of all it may still be right to be wary of technology sectors. While the extent of the fall in these sectors argues for a recovery, which must be odds on to occur, the fundamentals are less promising. Business investment rose by nearly 15% in the US in 2000 after a series of good years but the immediate outlook looks much less promising. Consensus forecasts are now for growth well below 10%.
Companies that have grown used to a rapidly expanding revenue line have not had to focus on cost control to the same extent as traditional industries. The problem has been managing the expansion rather than dealing with contraction and the adjustment in financial discipline needed in many of these companies in 2001 could be ugly. While the UK did not see quite the same level of investment in recent years, most of our technology companies struggle with far weaker industry positions than their US peers.
Market expectations are also quite different from autumn 1999 when the technology sectors soared. The interest rate rise in early September 1999 brought an end to the rally in the value sectors of the market. Investors turned instead to what was perceived to be the almost unlimited opportunities offered by the technology sectors. Such optimism is now seen as having been misplaced, and interest rates also look to be heading down.
On top of this, the financial structure of many of the technology companies remains perilous. Many of these companies will have to come back to the market at some stage but the reception is unlikely to be warm.
On the other hand, this area of the market undoubtedly contains many of the best growth opportunities. It is simply that investors are likely to be far more discerning and demanding in the future.
The pharmaceutical sector, along with other classic defensive sectors, has performed admirably in 2000 as investors have sought a safe haven. While economic uncertainties persist, these sectors are unlikely to perform badly, but if investors turn more positive on the economy, interest in these sectors may evaporate.
Within the Pharmaceutical sector, both AstraZeneca (patent expiries on key drugs) and Glaxo Smithkline (weakness in the R&D pipeline) face a relatively uncertain 2001 in comparison to their usual standards. The first whiff of an economic soft landing could also see a repeat of 1993 when post-ERM interest rate reductions propelled the cyclical sectors at the expense of liquid defensive sectors such as pharma
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