There’s nothing like a bubble to make the markets really exciting. You can make a lot of money in bubbles…if you get out in time (emphasis on the “if”).
It’s not very easy though.
It’s easy to get caught up in the euphoria of a peak. It’s easy to miss all the warning signs. It’s easy to give back all your gains at the end of it all.
There is a way, however, to tell when a bubble is forming, which sector it’s forming in, and when it will soon be time to get out. Today we’ll take a quick look at how they form, where the next bubble is forming (The end of the bubble era, as many predict, is not dead – a topic for a different day though so be sure to stay current with our 100% Free E-Letter the Prosperity Dispatch), and one screaming indicator the end is nearing and to get prepared.
Anatomy of a bubble
Bubbles start out innocently enough. They usually start with a pretty simple story. You know…something everyone can understand. A base begins to form. Shares in the sector start to move up a bit compared to the rest of the market. There’s some institutional buying.
This all happens when practically no one is watching. That all changes during the next stage; when the idea becomes tangible.
This is the key point of a bull market turning into a bubble. It’s when the idea really hits home for the average investor. Tangibility is the key. In the case of the energy bubble, it’s the point when gasoline passed $2 a gallon at the pump. In the dot-com bubble, it’s when the average investor starts trading stocks online, buying stuff from Amazon.com, and setting up their first e-mail accounts. It’s tangible. They can see it. It impacts their daily lives. It’s right in front of them.
Then the run-up continues to the cocktail party stage. This is the euphoric point. By this time, everyone knows about it and everyone is heavily invested. And a lot of people are making a killing on shares of companies that don’t make any sense at all. It’s when you have “idea-stage” companies generating $100 million or greater valuations.
It’s a great time, but it’s also the most dangerous time. By this point, most investors have been lulled to sleep. The story is ingrained in our minds and we have a tendency to forget the old adage, “Stocks go up stairs and down an elevator.”
Just take a look at agriculture stocks back in 2006 (This is one that is still fresh in all our minds).
Is it ever different this time?
Oil prices were setting 25-year highs, alternative energy was the hot sector, and ethanol was the solution. The mainstream media was trying to peg how high oil and gasoline prices would go. Practically everyone was focused on the daily ups and downs of oil prices and how much more oil would be needed to feed booming emerging markets at the time.
Meanwhile, some smart money was starting to collect many different agriculture plays. Fertilizer stocks had quietly doubled in the past 12 months and corn, wheat, and soybean prices started to move up too. Still, no one was watching.
Throughout 2007 that all started to change. High agriculture prices started to have an impact on the public. Prices for bread, wheat, and meat continued to increase. A $100 in groceries last year now cost $130. All of a sudden, the unfolding ag story was tangible.
In all of those “Top Stocks for 2008” columns in mainstream media featured once-unknown stocks like Terra Industries (NYSE:TRA, Stock Forum) and Potash Corp of Saskatchewan (NYSE: POT, Stock Forum).
How many people even knew where Saskatchewan is? It didn’t matter. “It was never coming to an end” and “you better get in now or else you’ll never be able to get in.” Or, my personal favorite, “It is different this time.”
It took three years for these stocks to walk up steps to gains of 500% to 1,000% or more. But it only took six months to ride back down the elevator. A few years of gains was wiped away in a matter of months.
Throwing their weight around
These ups and downs can be painful if you ride them out. The stock market is highly cyclical. By paying close attention to the cycles, you get in early and get out before it’s too late. The cycles allow you to make an absolute fortune.
The key thing of course is how to identify the cycles. Here’s one way.
One of the best indicators I’ve found for these long-running, wealth-multiplying cycles is the sector weightings of the S&P 500. The S&P 500 is made up of the largest companies on the U.S. exchanges. It contains everything from ExxonMobil to Bank of America and everything in between. It covers all sectors.
But here’s the thing, catching the right sector at the right time can pay off big. Of course, it takes a bit of analysis and a contrarian style to do it.
The table below shows the different sector weightings of the S&P 500 stocks.
If you look closely, you can see where optimism is too high and pessimism is too low for different sectors. The energy sector is the perfect example.
In 1980, at the height of the oil and commodities boom, energy sector stocks made up 25% of the S&P 500’s total value. At the time, oil prices were setting new highs and investors were flocking to oil stocks. They bid energy stocks up to the point where they made up one quarter of the entire S&P 500.
In hindsight, energy stocks had reached an unsustainably high level. Energy stocks are valuable (during “normal” periods make up between 10% and 15% of the S&P 500’s value) but they’re hardly worth so much relative to every other company. A decline was inevitable.
Then in 2000, when oil prices were bottoming out, energy stocks made up a paltry 6% of the S&P. This time, it was an unsustainable low. Now the energy sector makes up about 13.4% of the S&P 500 – right near the long-run average.
That’s why I’m encouraging everyone to look away from the energy sector. It’s in the middle right now. The energy sector could go up or down from here. Energy stocks going up – as we’ve seen – are hardly a sure thing.
The same is true for the financial sector. Financial services made up a lowly 6% of the S&P 500 in 1980. After two decades of across-the-board double digit earnings growth (which we are now seeing how they made those earnings) they formed kind of a “silent bubble.” Now, it has burst and financial sector stocks, as a percentage of the S&P 500, are working its way back to historical norms.
Then there are tech stocks. During the height of the tech bubble in 2000, the technology sector made up 30% of the S&P 500 – Unsustainable.
Riding the waves
Looking back it’s seems so obvious. It always does. If you use the table to look forward, it can be quite helpful. There are some waves forming and, if you focus on them over the next few years, you should be sitting pretty at the end of it all.
For instance, the healthcare sector has showed consistent strength relative to other sectors. Healthcare sector stocks have steadily increased from 5.61% in 1980 to 14% today.
Right now, I believe we’re still in the early stages of a very long bull market for health care sector stocks. The way the trend has been going, healthcare really will likely get booming in the next couple of years.
All of the fundamentals are there - aging population, more resources devoted to healthcare, technological innovation (i.e. genomics, robotic surgery, and stem cells). As these technologies make their way into the mainstream, they will become more tangible. Tangibility in the medical sector is when you know someone who was helped by one of these.
A big run for healthcare is coming. IF this long-term rising trend holds (very similar to the 30-year growth in the financial services sector) the healthcare sector will be one of the best places to have your money for years to come.
You should be able to pick out more than just a growing trend from the table though. There are also a few “unsustainable lows.”
For instance, the basic materials sector has plummeted in value relative to its relative value for the past 30 years. At 3.1% of the S&P 500, the materials sector is right near 30-year relative lows. It’s the extreme type of situation we’re always looking for. This, just like every other time the sector weightings reach extremes, won’t last forever. As a result, it could be time to start looking at the chemicals companies like DuPont (NYSE: DD, Stock Forum) and companies which excel at the basics, like Air Products (NYSE: APD, Stock Forum) and Praxair (NYSE: PX, Stock Forum) as potential places to sock away your “safe money.”
Also, telecoms have fallen quite a bit and are resting near lows. Utilities too. Although not at unsustainable lows like in 2000, the utility sector is out of favor as well.
It’s all relative
There is one key consideration here. You’ve got to remember these are all relative numbers since they are a percentage of the S&P 500. For instance, the utility sector increased from 2.36% in 2000 to 3.9% today. Good for a 65% increase. Not bad until you compare it to the overall return of the S&P 500. The index is down 41% from the start of 2000 so it offsets all the gains.
So, sector weight analysis is not a perfect timing strategy for short-term movements (nothing is). It can, however, identify the big, long-run opportunities long before anyone else is talking about them (think stodgy “old economy” utilities in the heyday of the tech bubble).
This is just one strategy I use to generate investment ideas from the top down. It also serves as a reminder to never get too caught up in any story. Peak oil, alternative energy, agriculture, the Internet…they’ve all had great stories and strong fundamentals behind them when they first got started. Eventually though, they just get too big.
All sectors reach that point when it’s “get in now, or you’ll never get in,” which never lasts. For now, remember it’s a buyer’s market. For stocks you’re looking at, set a price and wait for it to come to you.
If these tables show us anything, it’s that the market is cyclical and these sectors take years to play out. With that in mind, I still foresee the medical sector being one of the best places to have your money for the next 10 years.
As for the markets, there’s hardly ever any need to rush out and buy stocks. In a market like this, the window to get in on the ground floor will be open for a while. On the positive side of things, good things come to those who wait…and to those who “weight.”