The four best sectors

by , 30th November 2018

If you’re wondering which stock market sectors are most attractive for investors right now, a Nobel Prize-winning economist has some ideas.

The economist is Robert Shiller who is famous, amongst other things, for developing the CAPE (cyclically-adjusted price/earnings ratio.) This ratio compares share prices to earnings over a ten-year period, which arguably gives a more accurate measure of valuation than the conventional price/earnings ratio.

I met Shiller a couple of weeks ago when he was talking about two ETFs that were inspired by his work. Basically these ETFs invest in the market sectors that look cheapest using the CAPE ratio. I’ll come back to the cheapest sectors later in the piece, but let’s first take a look at the two ETFs.

They’re both managed by Ossiam and they’re value ETFs with a bit of twist. One is the Ossiam Shiller Barclays Cape Europe Sector Value UCITS ETF (CAPE) and the Ossiam Shiller Barclays Cape US Sector Value ETF (CAPU) is the other one.  

Here’s how the US one works. You start with 11 US stock market indices, and pick the five cheapest sectors using the CAPE ratio. (That’s one of the strengths of the CAPE ratio, you can apply it to countries, stocks or sectors.) Then one of those sectors is removed using a momentum screen. In other words, the sector with the highest downward momentum is removed from the five, so we’re left with four sectors.

The momentum screen is used in an attempt to avoid ‘value traps.’ The idea of the value trap is that you might be tempted to buy a stock or sector because it looks very cheap, but that ignores the fact that the stock or sector might be cheap for a reason.  A company might be trading on a price/earnings ratio of five, but if it goes bust a year later, it’s not a profitable investment. By using the momentum screen, you’re hoping that the market will ‘tell’ you which sector is the potential value trap. In other words, if a sector’s underlying share prices have fallen a long way in recent months, the market may know that companies in this sector face a major challenge, and share prices might not recover for some time.

Ossiam cites an example where the momentum screen helped the performance of the US ETF. When the oil price, and oil stocks, fell in 2015/16, it was a two-legged fall with a stabilisation period in the middle of the two legs. Without the momentum screen, the Ossiam ETF would have invested in the energy sector during the stabilisation period as energy stocks certainly looked cheap at first glance. But the Momentum screen kept the ETF away from energy stocks because the energy sector had been the biggest faller in the preceding few months.

The ETF is reconstituted each month when sectors can be moved in or out. All of the four sectors are equally weighted, so after the reconstitution, each sector comprises a quarter of the ETF. All the stocks in a sector are also equally weighted within that sector.

The US ETF was launched in 2015 and tracks the Shiller Barclays CAPE US Sector Value index. The ongoing charge for this ETF is 0.65%, which is definitely on the high side and higher than a lot of smart beta ETFs.

Ossiam says that the index has outperformed the S&P 500 by 3 percentage points a year since 2012

The European ETF is very similar. It uses the CAPE ratio and the momentum screen to pick the four most attractive sectors in Europe.

Sectors

So which are the most attractive sectors?

Well here they are, according to Ossiam:

US sectors

Communication services

Consumer Staples

Healthcare

Technology

European sectors

Consumer staples

Consumer discretionary

Utilities

Heathcare

***

You might be surprised technology is in the US list. How can that be when Amazon is trading on a price/earnings ratio of 63?

Well, I have a two-part answer to that. Firstly, Amazon isn’t even in the US tech sector. It’s in consumer discretionary. And secondly, there are plenty of good tech companies generating good profits and not trading on crazy valuations. Microsoft and Cisco are good examples.

Now I’m not guaranteeing these sectors will outperform in the next few years – far from it. But, given where we are in the cycle, I do think there’s a decent chance that value will perform relatively well over the next few years. So the Ossiam ETFs give you a way to play that theme. Alternatively, you could use the above sectors as a good hunting ground if you want to pick some value stocks yourself.

And I’ll definitely be keeping an eye on the CAPE ratio. Not just for sectors, but countries too.

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