Confidence Gone? – If So, It’s a Long Way Down for Some; A Buying Opportunity for Others


Our measure of skepticism shows whether investors are concerned that things might get worse from here or confident that they will get better. It is a measure of whether current valuations reflect current returns of capital (so by definition in almost all cases – earnings).  When we began the analysis back in May of last year, there was a healthy degree of skepticism in the sectors, which we felt was appropriate given that most sectors were over-earning versus history.  Since then confidence has grown – or skepticism has rescinded – earnings have generally improved further, but expectations that they can be maintained or even improved upon has grown.  This is a sign of real confidence – confidence that may well have reached its peak and changed direction over the last week – but particularly yesterday.


Setting aside the tragic events in Boston, the market had started the day very negatively because of more disappointing news about economic growth in China.  Economic news has been getting incrementally more concerning over the last couple of months, but it has been mostly Europe, and this has largely been ignored as “priced in”.  What may have triggered the sell off yesterday is something that we have been concerned about for some time, which is that the level of global activity is not high enough to support the earnings expectations implied in valuations – these were a stretch with a weak Europe – and look unachievable with a weak China also.

 low demand growth = weaker pricing = negative revisions

The sectors which today demonstrate the lowest level of skepticism – i.e. the most optimism – are the conglomerates sector (excluding GE), Transports (though mostly the trucking space), specialty chemicals, agricultural chemicals and coatings.  Of these groups trucking and coatings look the most expensive.

However, the market instinct will be to sell the traditionally volatile and more cyclical sectors, such as Commodity Chemicals, Metals and Paper.  These groups suffered the most significant sell offs on Monday, despite being, in some cases, less highly valued.

If we really have a weaker economy and stagnant demand, we are going to see price competition intensify in every sector, particularly if China looks to the export market to offset slower domestic demand.  Those sectors discounting a bright future have much further to fall than those that are not.

This may take some time to play out, but the cyclical names will continue to underperform quickly, as, with the exception of metals, they are not really cheap.

These selloffs always create opportunities and we would point investors back to aluminum and AA. Here is a sector that is already discounting the end of the world, and interestingly AA, while down 2% on Monday, outperformed most of the other cyclical names meaningfully, suggesting that it has found a bottom.

Other stocks that we would watch for an entry point would be NUE, FCX, X, DOW, DD.  Other cyclical names are too expensive today and would need to fall considerably before we took interest.  There are some inexpensive Capital Goods names, such as JOY, ETN, CAT, SWK and ITW, and we would look for entry points here also.

Plotting the larger cap names on a chart of value versus skepticism, we get the picture below: the closer to the top right the more valuation and expectations reflect earnings weakness and expected weakness – the closer to the bottom left, valuation and expectations reflect earnings strength and further optimism.


For more information about this methodology or any of our research thoughts please see our published research or contact us directly.

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