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Shares: Looking at the big picture

Created:
23 April 2008
Updated:
24 April 2008
Written by:
Simon Thompson

There can be nothing more infuriating than seeing shares in one of your well-researched companies underperform the stock market for no apparent reason. You check the company's website and there is no 'bad news' press release to explain the unexpected bombshell. You check cuttings in the national press, but find no mention of why your shares are going down. At your wit's end, you put in a call to the directors of the company, only to get a reassuringly 'good news' story. The fact is, sometimes there are just other forces at work driving share prices and the performance of whole sectors – forces that are well worth considering before you make your investment decision.

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Economic risk: seasonal investing

It's a well-known fact that equity markets make most of their annual returns in the winter and spring, but struggle to make headway from the end of April to the end of October ('Sell in May', IC, 4 May 2006). However, that doesn't mean we can't make money during the summer and early autumn – we just have to be smarter in what we invest in by understanding the risks we are taking on. For the record, in the past 20 years, the smart money has invested in high-yielding and lowly rated defensive stocks - utilities, pharmaceuticals and tobacco - during the third quarter, before rotating into lower-yielding growth stocks - IT, telecoms and technology – in the fourth quarter.

This reflects a change in investors' appetite for risk during the winter months (investors are more risk-averse in late autumn than they are when the approach of spring encourages them to be more complacent). It also reflects changes in economic risk, which is far higher in the winter than the in summer.

For example, manufacturing output traditionally slumps between November and January - often by more than 10 per cent - and recovers in February and March. These gyrations make the winter a time of economic risks, and investors need high returns to compensate for these. It's no coincidence, either, that returns in 'cyclical' sectors, such as mining, industrials and construction, are more seasonal than those in 'non-cyclical' ones, such as pharmaceuticals and tobacco.

For example, there are sound reasons why the housebuilding sector rallies strongly – in no fewer than 23 of the past 27 years – in the first quarter, producing a staggering 11.8 per cent return, on average (see 'Hot property'). And you would need your head examined if you invested in the household goods sector in the fourth quarter – it has fallen, on average, by 7 per cent in that three-month period since 1985. However, like the housebuilding sector, investing in household goods companies in the first three months of the year is a licence to print to money – it has been the best stock-market performer in the past 20 years in this period (for a full analysis of seasonal sector trends, see 'How to make 34 per cent from 4 phone calls.' and 'Make 26 per cent the easy way').

There's one final quirk. If you're torn between investing in a small-cap or larger-cap company, remember that small caps have proved to be more seasonal than larger companies. For example, since 1989, the FTSE Small Cap index has underperformed the FTSE 100 index by almost 5 percentage points between April and October, and has beaten it only four times out of 16. But it has outperformed in 10 of those 17 winters – by an overall average of 3.2 percentage points. Small can indeed be beautiful, but only if you get your timing right.

One note of caution, though, is that when equity markets are trendless, as they have been since May, volatility has a tendency to rise. This is rational, since market participants are uncertain as to where the markets are heading, and uncertainty creates volatility. As a result, during periods of weaker equity market conditions, seasonal investing becomes less reliable. For example, when stock markets were strong in the first three months of 2006, the cyclical mining sector put in a stellar performance as expected.

However, go back a year, when the FTSE 100 ran out of steam in February and trended lower until the end of April, and the mining sector followed suit and tracked downwards, too, dogged by concerns about growth prospects in the industry.

Economy: interest-rate cycle

No matter how well you've looked into a company's trading record – and no matter how attractive the investment case is – you also have to consider how movements in government bond yields and interest rates are likely to affect share prices. And needless to say, it's far better having a tailwind behind your shares than fighting an interest-rate headwind to make a profit. As GK Chesterton once said: "The disadvantage of men not knowing history, is that they do not know the present."

Luckily, history gives us several clues as to how stock-market sectors have reacted to macroeconomic events in the past.

Real interest rates

If you want to make money from telecoms companies, then you would be best advised to keep a close eye on the yields on indexed-linked gilts (linkers). Over the past decade, when yields have risen over a three-month period, the telecoms sector has – two-thirds of the time – gone on to underperform the equity market by around 3.5 per cent over the following three-month period (the virtual opposite is true when linkers fall). The reason for this is that a rise in linkers' yields, or real interest rates, implies there are inflationary pressures in the economy.

This spells bad news for telecoms stocks (and technology and life insurance shares, too), whose market values are determined by the future levels of cash flows that these businesses generate. So the value of those cash flows are worth less in today’s money if higher interest rates are needed in the future to quell inflationary pressures.

By contrast, rising real interest rates are associated with good future returns on mining, chemicals and paper companies, which are all beneficiaries of price inflation.

You can track changes in linkers' yields on the Treasury website, www.dmo.gov.uk, which also provides useful graphs and price data for every single issue.

Short-term interest rates

A one-percentage-point rise in short-term interest rates is associated, on average, with falls of 3-5 per cent in the general retailing, banks, mining and tobacco sectors, but rises of just over 2 per cent in the pharmaceuticals, food retailing and software sectors. However, the real money is to be made in interest-rate down cycles. In fact, looking back over the past 20 years, there have been six cycles in the UK when interest rates have been cut, during which time the FTSE All-Share index has risen by an average of 11 per cent. Not surprisingly, financial companies are a major beneficiary of looser monetary policy – the best-performing sector is banking (28 per cent rise on average) followed by speciality finance (21 per cent).

Cyclical sectors, such as construction, automobiles, leisure, steel and mining, have also produced returns above 20 per cent in these six rate-cutting cycles. What makes that especially worth noting is that some economists are predicting that there will be cuts in UK interest rates next year.

Economy: retail sales

If you think general retailing shares are likely to be badly hit by slower retail sales, as many doom-mongers forecast, think again. Since 1990, the correlation between retail sales volumes and the general retail sector has been slightly negative. Falling retail sales do, however, have a negative impact on real-estate companies (a 1 per cent drop in retail sales is associated with a near 4 per cent fall in share prices – reflecting increased risk of tenant default and property voids), and a positive impact on pharmaceuticals and telecoms stocks (where a 1 per cent fall in retail sales has led to 5 per cent higher returns for both sectors). But for most companies, the impact is insignificant. You can follow changes in retail sales statistics at www.statistics.gov.uk.

Commodities: oil prices

It would be logical to believe that the oil sector benefits most from rising oil prices. But you would be very wrong to believe this. That's because a strong oil price is usually a sign of a strong global economy, which also benefits cyclical stocks.

In the past, shares in mining, media and IT companies have all been more sensitive to oil prices than shares in the oil majors, although in truth sectors aren't really that sensitive to oil. That said, airlines most certainly are sensitive and it’s no coincidence that airline shares have taken off in the past six weeks just as the oil price went into a nosedive. For a carrier like BA , the company's fuel bill alone accounts for an eye-watering £2bn out of its £9bn annual revenues. That's a pretty significant sum considering the airline is forecast to earn profits of around £700m this year.

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