As sectors get popular, the stocks in the sector get bigger and expand weight in the index
Just like everything else in the world from technology to fashion, from political leaders to celebrities, which run in cycles, so do sectors in financial markets.
The best way to assess the rise and fall in the popularity of a sector, in our view, is to watch its weight in key indices. As sectors get popular, the stocks in the sector get bigger and expand weight in the index. Invariably, more stocks from the sector gain an index entry, making the sector weight swell further.
The sector weight then hits a peak and follows a predictable decline. The sector weight rises as the street raises long-term growth forecasts. Ultimately, prices (read valuations) rise to a level that overestimates future growth leading to what is usually a dramatic drop in the weight of the sector.
Learning from the past: There are four examples from India’s history of the past 20 years that illustrate the life cycle of sectors. In this exercise, we define the market’s extraordinary love for a sector when its weight in the index crosses 25% - i.e., a sector accounts for one quarter of the index (MSCI India index).
The first incident was the great boom in material stocks during the mid-90s triggered by industrial de-licensing and the quest of companies for global scale capacity in the sector. Things turned sour as India put up excess capacity and the final fall came in 2002 when Reliance Industries (RIL, Rs 786) was transferred to the energy sector.
The explosion in materials was followed by a spurt in consumer staples’ weight. The reasons were similar to today. Investors were looking for high return and high free cash flow companies.
Valuations soared and the sector hit the pinnacle of glory in the autumn of 1998. This was followed by the fizz in the tech sector in the late-90s to the early months of the previous decade. Just before the tech boom, the only technology stock in the MSCI India index was Siemens – arguably not anymore a tech company. The tech bubble attracted more tech names to the index and sector the achieved a 45 per cent weight in the index at its peak.
The previous bull market of 2003-07 saw the rise of the energy sector led by the ascendance of Reliance – though the peak weight of the energy sector (23 per cent) did not compare well with the peaks of materials (40 per cent), consumer staples (35 per cent) or tech sectors.
There have been other sector bubbles such as consumer discretionary in 1995, telecoms in 1997, healthcare in 2002, industrials in 1995 and 2006, and utilities in 2008. However, the size of these bubbles did not match those of the above four occurrences.
Which sector is in vogue these days: Intuitively, most market participants will say it’s consumer staples all over again. However, the weight of the consumer sector is only 10 per cent at present – the weight is climbing up from the big destruction in relative value the sector witnessed from the late-90s. The sector that is riding the wave is actually financials, driven by the market’s growing love for private sector banks.
Financials account for 28 per cent of the index weight – past the 25 per cent threshold. However, two nuances about the financials weight differentiate the current situation from the episodes of the past:
>> The rise in the sector’s weight has been steady rather than disruptive as has been the case with sectors that hit froth territory in the past.
>> It seems like a second wind for financials – the sector’sweight hit a peak of over 30 per cent at the start of 2008 and then promptly collapsed to below 20 per cent in the subsequent 15 months.
>> It is quite possible that this could have been the correction in weight associated with purging of bubbles, though like the rise the fall too was not disorderly enough to be classified as cleansing.
Just for comparison – the materials weight went from 40 per cent to 5 per cent, consumer staples from 35 per cent to 4 per cent, energy from 24 per cent to 12 per cent and technology from 45 per cent to 11 per cent during their weight correction phases.
Financials may continue to gain weight in the short term (12-18 months) but as the weight climbs higher, the risk of a fall will keep increasing. We shall not be surprised if an adjustment happens and consumer names find more space in the index.