Full Circle

Farr, Miller & Washington prides itself on building diversified portfolios of high-quality stocks and bonds. Though industry-sector weightings are certainly monitored to ensure adequate diversification, investment decisions are primarily made based on a bottom-up selection process. Having said that, we have found that tracking the weighting of the different industry sectors in the S&P 500 over time has sometimes been a useful investment tool. For instance, it is easy to tell (in hindsight, of course) that the Technology sector, having reached 29% of the S&P 500 at the end of 1999, was clearly in bubble territory. Other instances of bubbles over the last twenty years are evident as well, if not so obvious. The Energy sector was certainly toppy (again in hindsight) in the 2007-2008 period when the price of oil rose to over $140/barrel and the sector reached 13% of the index. Similarly, the Financial sector was overvalued in the years preceding the financial crisis (2002-2006) when the sector held top billing in the S&P 500 at 21%-22% of the index.

 

155Source: Bloomberg

Obviously, the next question becomes this: Are there any sectors that look overly attractive or unattractive now based on this sector-weighting analysis? To determine the answer, we compared each sector’s current weighting in the S&P 500 to its average weighting over the past 20 years. The results, contained in the table below, were somewhat expected in some cases and somewhat surprising in others. For instance, we would expect that the Technology sector would be a bigger portion of the overall index following years of technological innovation and competitive dominance in the United States (think Apple, Google, Facebook, etc). Similarly, it makes sense that the Health Care sector has gained representation in the index due to rising health care costs and aging baby boomers.

More surprisingly is the fact that the Financials sector, which currently represents about 16.5% of the total S&P 500, is now roughly in line with its 20-year average. After all the turmoil in the industry over the past five years, the sector still represents the second-largest sector in the economy behind Technology. The regulatory backlash following the crisis obviously succeeded in recapitalizing the banks and making the financial system much more stable and secure than it was just a few years ago. However, the regulators also appear to have enriched a lot of the folks who created the mess in the first place. Since the March, 2009 low for the S&P 500, the Financials sector has returned a massive 260% as a group – the second-best sector performance behind Consumer Discretionary. And who are some of the biggest individual holders of these stocks? You guessed it – bank management teams.

 

156Source: Bloomberg

While admittedly this type of analysis has a lot of problems, it does serve as another confirmation for our belief that the Financials sector has returned to “fair value”. Those pundits expecting banks and other financial stocks to return to the high multiples preceding the financial crisis are likely to be waiting a very long time. While the system (as well as individual banks) is much safer now that it has been recapitalized, higher capital requirements and increased regulatory scrutiny will suppress returns and profitability compared to historical levels. We therefore suggest that investors start to look beyond Financials for outsized returns in the future.

Peace,

Michael