In the course of doing a performance attribution for the S&P 500 year-to-date last week, I noted that the S&P 500 ex Energy, Materials and Industrials, is pretty close to flat so far this year on a total return basis.

But is it correct to conclude that the “healthy” sectors of the S&P will continue to be relatively immune to the economic illness caused by the price collapse of global mining commodities?   …or will they eventually be dragged down if, as I expect, commodity weakness continues for an extended period of time.

This isn’t as silly a question as it might seem at first.

In the early 1990s I was asked by the board of the company I worked for to present my views on the stock market in Japan at that time.  I created a presentation that divided the Topix index, which was trading at about 70x earnings, into three parts:

–highly speculative property-related companies that were trading at around 500x earnings and made up 10% of the market

–export-oriented industrials, such as the autos or tech companies like Canon, which were trading at 15-20x earnings and made up 30% of the market, and

–everything else, which made up 60% of the market and traded at around 25x.

I said what I believed:  that, while the index might do poorly as the speculatives came back to earth and the bulk of the market went sideways, the export-oriented stocks were cheap and would go up significantly in price–not only in yen but in dollars, too.  My model was the behavior of the US market throughout the second half of the 1970s, when former speculative favorites, the Nifty Fifty, were crushed while everything else went up.

An aside: a famous finance academic on the board, who made it clear he had not sought the opinion of a mere “practitioner” like me, objected that the low dividend yields of Japanese stock proved they remained wildly overvalued.  A little embarrassed (for him), I had to explain that Japanese tax laws did not provide the same preference for dividend income that the IRS did. In fact, dividend income was subject to income tax at an extremely high rate (up to 90%) in Japan.  Because of this, taxable investors (the majority at that time) had a very strong preference for (untaxed) capital gains.  Companies tended to make negligible cash payouts and to use stock dividends as a substitute.

Embarrassingly (for me), it turned out that my reasonable analysis was completely wrong.  Yes, the exporters were cheap, but for the next decade they significantly underperformed similar-quality companies elsewhere in the world.  In this case, the general economic funk that engulfed the Japanese economy hurt the stocks of all firms listed there.  There was no escape.

my thoughts

Thee aren’t a whole lot of relevant examples of this kind of situation to generalize from.  (Another might be the worldwide collapse in the price of mining commodities and of commodities stocks from 1982-86, which did not impede the upward progress of global stock markets from mid-1982 on.)

My hunch is that the contamination of “good” stocks in 1990s Japan is more a function of the continuing economic malaise in that country than of anything else.  What’s somewhat troubling is that the US today is very similar demographically to Japan back then, when lack of workforce growth was a significant contributor to Japan’s stagnation.  We have the same woes of extremely low interest rates and an impotent legislative arm tied to the status quo and unwilling to use fiscal policy to bolster the economy–another set of lead weights dragging Japan down.

At the end of the day, I’d argue that the US is inherently a much more dynamic country than others in the developed world.  Also, I see the commodities collapse as much more like an external shock than a sign of weakness in the domestic economy in the way the property collapse in Japan was.  So I see the chances that commodities/commodity stock softness will cripple the rest of the US stock market as low.  But there are enough similarities between us today and Japan 25 years ago to make me vaguely uneasy.