We have extended our “normal valuation” analysis to look at skepticism/optimism, defined as whether the valuation of a sector adequately reflects the underlying current profitability or expected profitability of the sector*. *

*Because I have been covering basic industries for so long, I have become programmed to expect disappointment and am now naturally negative. Consequently, we are going to label it the Skepticism Index rather than the Optimism Index.*

We have constructed this index by summing our discount from mid-cycle value index (introduced in our initial report) with a similar analysis of how significantly different return on capital (ROC) is from trend within each sector. The index is high when both the discount and ROCs are high and vice versa. We are summing two standard deviations, so any number above 2 or below -2 is very significant.

For most sectors a high Skepticism Index is followed by aggregate stock performance that exceed the market over a 6 month period, but in most cases the variability of this outcome is quite high, so that while the average is high, one standard deviation of outcome is generally higher than the average. In reverse, we find that a low Skepticism Index (low profitability/high valuation) yields equally interesting relative downside, but with similar variability.

Today, the compelling high is the Metals and Mining space, as discussed in our recent research, and there is not a compelling low. While the Paper sector screens as expensive in our normal value framework, it does not appear much out of line with its current above trend return on capital in this analysis. **While Chemicals looks fairly valued in this analysis, commodity chemicals has a high Skepticism Index and we will follow up with additional research in this sector.**

(Click to enlarge)