Monday Morning: Sector overvaluation is in the making

One would think that the financial sector stocks would be languishing, given all the bad press over the past 12 months.

One might expect that the conflict-of-interest scandals, the threats of lawsuits arising from them and the huge settlement the leading firms agreed upon would have damaged their value in the eyes of investors.

But that’s not so.

In fact, the financial sector is reaching an all-time high in terms of its historical weighting in the Standard & Poor’s 500 index, according to new research by the Leuthold Group in Minneapolis.

At present, the financial sector stocks in the S&P 500 represent 20.9% of the market value of the index, up from 16.2% in 1999 and only 7.5% in 1990, and close to its all-time high weighting of 21% in August 2002. The historical median weighting for the financial sector is 9.3%.

This gives rise to a couple of thoughts. First, sophisticated investors see the punishment of the financial sector for ripping off the public with biased research as a slap on the wrist. They see no long-term harm to the prospects of these firms.

And more importantly, they clearly believe the financial sector is the most attractive sector in the market at present.

That’s probably because as the economy picks up, as companies begin to borrow money again to finance the expansion of business and as investors begin to return to the market, the earnings of financial sector companies should surge.

The investors are pricing the financial sector stocks on the basis of future earnings.

But that, of course, means the smart money has already discounted the earnings pickup, and will move out smartly when it shows signs of arriving, or at the first hint of disappointment.

market corrections

And that probably explains why, as the analysts at Leuthold point out, the sectors that surge to highs in terms of S&P 500 ratings usually “experience large corrections.” And fairly rapid ones at that.

The most recent example is the technology sector. That sector climbed to a peak weighting in the index of 34.5% in August of 2000. Its current weight is only 15.1%.

Similarly, the energy sector spiked to its peak weighting of 29.2% in 1980 toward the end of the last major oil crisis, before plunging 83% to its January 1999 low of 4.9%. Even now, the energy sector accounts for only 5.8% of the market value of the index.

Even health care climbed quickly from a weight of near 9% in 1999 to an all-time high of 15.7% in April this year and slumped to 14.5% in May.

So it seems a surge in market-value weighting in the S&P 500 index to or near a high might be another indicator of a sector becoming overvalued in the market, and of a time to pull back from the sector.

The Leuthold study also suggests that investors should wait some time after the slump begins before buying stocks in a sector.

Though the initial correction can be sharp, it generally takes several years for the sector to bottom out.

Since a sector’s weighting in the S&P 500 index is an indirect confirmation that the sector is becoming overvalued, it’s useful because it will show which sectors are most out of line when more than one sector is becoming overvalued in terms of price-earnings ratios.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.