Forget 2009. Some of the wisest heads in the City reckon recent movements in the stock market are more reminiscent of 1999.
The pre-millennial analogy might seem odd given the vast difference between the latter stages of the dot-com boom and the aftermath of last autumn’s savage equity sell-off.
But the consequences of both are much the same: just as a surge in technology stocks left “defensive” or “old economy” stocks - such as drugs, tobacco and food producers - severely out of favour, so too has the sharp rally in so-called “cyclical” stocks since March’s market low.
Speaking last week, Neil Woodford, Invesco Perpetual’s highly rated equity income fund manager, said: “I find myself feeling strangely back in the sort of environment that I was nearly ten years ago, when I saw the upside opportunity in the market in stocks the market hated - because they were old-economy stocks. Rolling on ten years, I find that, in very different circumstances, we are in a similar polarised market”.
That view is borne out by the numbers. Citigroup finds that, since the end of last year, European defensive stocks have moved from a 70 per cent premium to the wider market to a 20 per cent discount (see chart, top). From fearing the end of the world, investors have started to fear missing out on the beginnings of a new bull market, selling safe-haven stocks in order to plough back the proceeds into riskier alternatives more geared to economic recovery.
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At a sector level, that unpopularity is even more pronounced. On the basis of forward earnings multiples, Citigroup calculates that pharmaceutical shares are trading at their lowest level since the mid-1970s. The prospective dividend yield on telecom stocks is now 80 per cent higher than the rest of the market - a sure sign of being ostracised.
And a basket of the US bank’s most favoured large-cap defensive companies - a selection that includes British American Tobacco (BAT), GlaxoSmithKline, Unilever and Vodafone - now sits at a forward multiple of less than 10 times earnings, something it has done only once before in the past 20 years.
The move out of defensives into cyclicals over the past three months has another distinguishing feature: the speed with which it has happened. It is part of a wider switch between “risk” and “risk-free” assets, such as government bonds and cash, that is virtually unprecedented in its pace - certainly more extreme than anything seen at the bottom of any recession since the 1970s. Whereas in the early 1990s and early 2000s it took up to six months from the stock market’s bottom for “risk” assets to consistently outperform their “risk-free” rivals, this time round it has taken only a matter of weeks.
So are defensive stocks now far too cheap? Mr Woodford describes the sort of soundly financed recession-resilient stocks in which he invests, mostly tobacco and drugs, as “profoundly undervalued”.
Evolution Securities would seem to concur. The UK investment bank believes that the recent strong bounce in stock markets will lose momentum, and that the recent underperformance of defensive stocks will steadily start to reverse. Like Mr Woodford, Evolution is profoundly sceptical of the “V-shaped” recovery that the stock market has begun to price in. Rather, it subscribes to the “W-shaped”, or “double-dip”, school of thought: cyclical stocks will retreat once again when it becomes clear that the foundations of economic recovery are insubstantial.
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In a review of the consumer staples sector - which encompasses everything from washing powder to whisky - it favours tobacco stocks most of all, noting that the sector has underperformed the European stock market by 22 per cent since March. Its starting point is that the sector’s pricing power in recession has been underappreciated. Demand for cigarettes is relatively inelastic, while only a small proportion of their selling price is determined by the manufacturer (relative to that which is fixed by government through taxes). This means that what are small percentage price rises for consumers prove significant for the producer’s sales and, by extension, profitability. For example, April’s first-quarter figures from Philip Morris International showed, although tobacco volumes were flat, that it was able to increase revenues by 6 per cent through price rises. Charles Manso de Zuniga, Evolution’s tobacco analyst, contends that the now-consolidated state of the sector means there is little incentive for its constituents to undercut each other on price. Equally, he downplays the likelihood of sharp tax rises on cigarettes by governments that are seeking additional revenues to repair their public finances; previous such measures in Britain, France and Germany only served to boost blackmarket activity.
With the likes of BAT and Imperial Tobacco able to keep profits and dividends growing (they yield 6per cent and 5percent respectively), Evolution believes their attractions will increasingly come to the fore.
For his part, Mr Woodford holds nearly one fifth of his portfolio in tobacco stocks, which produced eight straight years of share-price growth from their turn-of-the-millennium low. Owners of Invesco funds, and defensive stocks in general, must trust that his sense of d?jà vu is true.