You can see a lot just by observing, Yogi Berra famously said of the national pastime. The adage also applies to the stock market as well as to baseball. But in the process of observing equities and thereby seeing a lot, logic isn’t always forthcoming.
Consider the tally of the ten sectors that comprise the S&P 500. Ranked by the change in estimated operating earnings for this year’s first quarter over the actual year-earlier quarter, the materials sector is the clear winner, posting a gain of 67%, according to Standard & Poor’s. In second place was the energy sector (+40%), followed by utilities (+30%).
So far, so good, although a very different message comes from Mr. Market by way of the market capitalization he assigns to each of the S&P’s ten sectors. That starts with financials, the leading S&P 500 sector by market cap, topping the list with a 20% weighting in the S&P 500, as of May 25. This despite the fact that financials came in seventh in the ten-sector race for the pace of raising earnings in this year’s first quarter over the comparable period in 2004 with a 7.8% advance.
It’s also interesting to note that materials, even though the group posted by far the fastest rise in earnings in the first quarter from a year earlier, was dead last in terms of market cap, grabbing a measly three percent share of the S&P 500. Energy fared a bit better with an 8.2% market-cap weighting in the S&P, although utilities fared worse with a 3.2% weighting.
Perhaps Mr. Market is looking at net income as the arbiter of market cap. Alas, looking at the S&P sectors through this financial prism doesn’t necessarily lend more clarity. Indeed, the energy sector claimed more than 13% of the S&P 500’s net income in the first quarter, second only to the 27% for financials. By that gauge, one could argue that energy deserves second billing in the market cap ranking. In fact, energy comes in seventh in a field of ten on the market-cap scale.
On the other hand, materials holds just a 4.2% share of S&P 500 net income, and utilities weigh in at 3.8%. That seems to jibe with the low market-cap ranking for each. But this analysis satisfies only if the pace of earnings increases, for which both sectors excelled, is irrelevant.
Investors, of course, are primarily interested in returns. But even this universal metric leaves questions. Indeed, the S&P Energy ETF (Amex: XLE) still leads the pack this year with its shares rising 14% through yesterday. Given the bull market in oil, who could argue? Ok, but why has the S&P Financials ETF (Amex: XLF) shed 4% year to date? Yes, we’ve heard that interest rates are headed higher, the bond market’s judgment notwithstanding. But financials are far and away the leading market-cap sector in the S&P 500. Why haven’t they fared better as an investment? Should we conclude then that financials’ market cap is too high, and thereby due for a fall? Or, perhaps energy’s market cap is too low and due for a rise, in which case the constituent stocks are set to climb further?
The mystery thickens when you consider that the S&P Materials ETF (Amex: XLB) has lost the most this year compared with its sector brethren, posting a 6.3% loss in 2005 through yesterday’s close. Rapid earnings increases apparently don’t mean much to Wall Street in 2005.
On the other hand, the S&P Utilities ETF (Amex: XLU) has climbed 7.5% this year even though its year-over-year earnings grew by less than half as fast compared with the materials sector.
The market may be efficient, but it’s not always logical.