Financials to keep performing

We've had a really interesting rotation come through the market over the past 12 months. The baton of leadership has unquestionably changed from your safe defensive companies, your consumer staples, your health care. These companies that people were secure and felt comfortable around - and then started paying very high evaluations for - to energy, materials, financials. That's probably the three that have stood out in terms of performance.

We know that the commodity prices have improved sharply, so that's perfectly logical that those stocks have improved, and typically people underestimate the leverage to that and probably will probably miss a bit of the extent of it. I'm at this stage of the view that that strength in the commodities will probably persist a little longer than expected, but then we'll give up ground possibly in the second half of next year. It's not something one would want to embed in a portfolio for three years, a commodity call. It's not as though we're coming from massive shortages of commodities and strong demand. This is more a cyclical factor I would argue.

The financials are more interesting in that as interest rates rise, banks do better. That's simply because they borrow short, deposits, the greatest example, and lend long. Let's say they're lending a company money for three to five years, the higher the rates are at the longer end compared to the shorter end, the more money a bank will make, and in simple terms, therefore banks should make money as longer term yields rise, which is what they have been doing. That simply supports the rally in financial stocks we've been seeing. That's probably going to persist for a while, and I think you can look favourably to stocks that benefit from that. That's banks. Domestically here we've seen companies like QBE, even companies like Computershare which have cash surpluses which they invest in these markets, they all are beneficiaries of that trade.

The third iteration might be industrial companies, which will benefit from a greater degree of activity. This may be associated with some infrastructure spending, although it feels terribly premature. That's got to be passed through various governments and then actually hit the ground. That will take probably at least a year, but that won't stop people from buying in anticipation of improved outcomes there and perhaps some of those domestically cyclical stocks in certain areas. Even, for example, Germany domestic demand is extremely strong at the moment and stocks involved in domestic demand there are doing really well. I think some of those cyclical industrial/consumer discretionary stocks are going to be the ones that will find favour.

It's not to say that some of the big global companies are necessarily going to do worse, but they probably run ahead of themselves in terms of valuation and also quite simply because people are rotating out. So in other words, if they wanted to buy the bank they're going to be selling some of those stable consumer staples or even some of the IT companies in which they've done well for the last few years. You've got to be aware that people will sell something to buy something else within their profile that they're managing on behalf of whoever it might be. That means they sell off some stocks in order to buy the others, and that means there is a differential performance between the two.

Another way that some people describe it – though it's not as common in the domestic market because we don't have the depth of stocks – is a rotation out of what's called growth into value. And that means, again, the stable growth stocks, they've been five years the favoured ones. Where as value says, "I'm going to buy things which are undervalued based on their likely earnings potential over time."

It may be that some of those stocks are actually trading on apparently high PE's, but because they have the potential to grow their earnings at a really fast clip, which often they're underestimated by the market because people underestimate operating leverage in companies. They're underestimated on the downside, that's why profits fall more than expected. And they will underestimate it on the upside because profits will rise more than expected. You've seen some evidence of that here, like mining services companies trading at very high multiples. I'm not suggesting they are justified, but the logic would be is that that earnings growth cycle is going to be underestimated in what be a 20 times PE today, which might be expensive, becomes 10 or 15 very quickly because the earnings catch up very quickly with that.

Some of these beaten up industrials, disliked industrials, which have either operating leverage - possibly some of them have fixed themselves up a little bit quietly in the background- either come across as very cheap or actually could come across very expensive, so it takes quite a bit of skill to do value compared to growth. You need to understand what you're looking for.  I don't want to undermine what people do, but I feel growth is always easier. It's easier that globally a company like Nestle or domestically a company like CSL is going to grow 10%. That's not too hard, but picking a company that's changing pace or has gotten underrated earnings potential is a much harder task.

It's a bit of a buyer-beware market. It's going to catch a lot of people out. In the last months of this year we've seen quite a lot of the funds under perform the index and for these reasons, and it will be interesting to see whether they're prepared to shift the emphasis during the course of next year if this becomes a confirmed trend.