A Look Back on 2012

In this week’s Market Commentary, I thought I would review the performance of the market in 2012 by industry sector and see if we can draw any conclusions from this data. We believe it is useful to periodically evaluate which sectors have been most and least favored by investors. Many times this information can tell a story about the direction of the economy. So let’s get to the numbers…

The chart below shows each sector’s performance within the S&P 500 for the year-to-date. Below the chart we provide our observations.
S&P industry sector

-The two best performing sectors, Financials and Consumer Discretionary, are generally considered very cyclical sectors. The fact that cyclical sectors led the market higher could suggest optimism about the pace of economic recovery in the future. These sectors also derive the overwhelming amount of their revenue from domestic markets. Therefore, investors appear to be relatively bullish about the prospects for the domestic economy in 2013. In particular, it seems that the US consumer may be in better shape to resume spending following years of hunkering down and paying off debt.

-The fact that Financials did so well could be suggestive of a number of different trends. First and foremost, we believe investors were attracted to the sector because valuations had become so cheap in the aftermath of the Great Recession. Second, many different indicators support the notion that the housing market is on the mend. Third, we are getting closer to more clarity on regulatory issues, including capital requirements for banks and other issues such as the Volcker Rule. And finally, investors may be speculating that interest rates are set to rise next year. Given the fact that low interest rates have caused margin compression at banks, higher rates would be a welcome trend. Taken together, these factors could lead to improving earnings growth and visibility at the banks and other financial firms. It appears that better earnings visibility has made the sector “investable” again.

-Two other cyclical sectors were laggards in 2012. Energy and Basic Materials underperformed the market thus far in 2012. We believe this underperformance is reflective of concerns about the global economy. Europe, the world’s largest economy, appears to be in recessionary territory, while growth rates in China and other emerging markets have slowed from the blistering pace of earlier years. Lower growth in these key regions means lower demand for commodities.

-The Utilities sector within the S&P 500 has actually posted a loss so far in 2012. Investors in utilities, who derive a large portion of their total return from dividends, may believe that the long trend of lower interest rates is coming to an end. To the extent that Utilities and other high-yielding stocks are utilized as substitutes for fixed-income investments, the weak performance of Utilities in 2012 makes some sense.

-Consumer Staples, typically one of the most defensive sectors of the market, lagged in 2012. This underperformance is reflective of the “risk on” trade. Investors have been emboldened by the Fed’s aggressive monetary policy, leading them to favor sectors that have the potential to go up the most and avoid the sectors that offer the most protection during periods of declining stock prices. Moreover, it appears that investors have a puzzling degree of confidence in our ability to avoid the looming fiscal cliff. For our part, we aren’t so confident at this late stage.

-Despite an election that threatened to repeal Obamacare, Health Care outperformed in 2012. We believe Heath Care stocks, like banks, had been too severely punished and offered valuations too compelling to refuse. While many questions remain for the future, Health Care stocks should continue to offer a good balance of defensiveness and opportunity.

Overall, we’ll certainly take the nearly 15% increase in the S&P 500 in 2012. Had we been offered this return at the beginning of the year, we would have jumped at the opportunity. But while the fourth straight year of solidly positive returns is gratifying, we still see reason for caution in the year to come. This is not a time to become overly optimistic or complacent. Valuations remain attractive for high-quality blue chips, but we believe the premium for defensiveness will return at times during the year to come.