We’re all looking forward to the post-Covid economic upturn. But which stocks would benefit from this? The answer could be: most of them.
My chart shows the point. It shows that there has been a close correlation between valuations on the All-Share index and Markit’s purchasing managers’ index (PMI) for the manufacturing sector, which we can use as a measure of cyclical conditions. High PMIs (a sign of a strong economy) have been accompanied by low yields and low PMIs such as last spring and in 2008-09 have seen high dividend yields.
Many sectors’ dividend yields have an even stronger correlation with the PMI than this. These are mostly cyclical ones as you might expect, such as chemicals, engineers, support services or travel and leisure.
Equally, the sectors whose valuations aren’t so sensitive to the PMI are also the ones you might expect, such as tobacco, food retailers, utilities and pharmaceuticals. Defensives are usually good stock picks, but they are likely to underperform in a strong economic upturn.
There are, however, some sectors that aren’t as responsive to this measure of cyclical conditions as you might expect.
One is mining. It has its own cycle, which is more responsive to emerging market conditions than UK ones. In 2015-16, for example, mining stocks halved even while the UK economy grew steadily.
Another is construction. It can be a lead indicator of cyclical conditions rather than a coincident one. Construction stocks slumped in early 2008, for example, even though the PMI pointed to the economy holding up.
Both sectors now carry a warning. Both have done well since last spring. But this raises the possibility that these might now be pricing in a lot of the coming upturn.
But is the rest of the market doing so?
One reason to fear it is is that the dividend yield on the All-Share is below its long-term average, suggesting the market is pricing in the resumption of some of the dividends that were suspended last year, and perhaps pricing in some of the upturn too.
Luckily, though, there’s also a reason for optimism here. It lies in a fact pointed out by Harvard University’s Matthew Rabin. He shows that we often project our current tastes into the future and so fail to foresee that they will change. This is the case even when such changes might seem obvious; people pay more for convertible cars or houses with swimming pools in the summer than they do in the winter, for example. This suggests that even if we correctly anticipate that a recovery will raise earnings and dividends, we don’t fully anticipate that it will also raise our appetite for risk and hence demand for equities. And so share prices can rise even during a recovery, which we all see coming. Hence the pattern in my chart – a contemporaneous correlation between the state of the economy and equity valuations.
Right now, the PMI is slightly above its post-2007 average. This doesn’t, however, mean it cannot rise further. The index measures the proportion of companies enjoying increased activity. As the upturn gains traction, more and more companies should be in this position. So even if the average gain for each company is small, the mere fact of many companies sharing in the upturn would drive up the PMI. And the width of the upturn could create a feel-good factor for stocks.
The danger for equity investors is not so much that the PMI will stay low as that the upturn might not be very long-lasting.
Of course, we’ll see a strong recovery as pent-up demand is released – not just from consumers but from some companies too as they enact expansion plans that had been put on ice because of Covid.
But what happens afterwards? Western economies were stagnating before the pandemic for many reasons. The pandemic hasn’t removed these reasons – and might in fact have strengthened some: memories of the surprise downturn and fear of a future pandemic might deter future investment for example. There’s a danger, therefore, that growth will fall back after its post-Covid spurt.
Yes, cyclical stocks could well enjoy a good upturn. But the thing about cycles is that they move down as well as up.
