An overdue downturn is currently taking place in the stock markets. And by yearend, a clearly established decline will be in place. Yet, it is never too early to be on the hunt for the stocks that potentially will be the leaders when the markets eventually turn up.

What leads in one cycle does not lead in the next, as new leaders usually come from unexpected places. After all, when the great bull market peaked in 1999-2000, how many investment managers recognized the ideal switch would be into energy and mining stocks?

Think of companies or industries you consider “trailer trash,” and take a dispassionate look at them. You may be surprised at what you will find.

Reviving earnings are, of course, the key indicator in recognizing new growth potential. You can also isolate potentially bullish stocks and indices by comparing price trends and relative market capitalization.

Energy stocks, in particular, have showed how much an apparently neglected industry can grow. In the short period of the past four years, energy stocks rose from 14% of the Canadian market’s capitalization — as measured by the S&P/TSX composite index — to 30%.

While energy doubled, relative valuations of other sectors — such as health care, information technology, consumer staples and consumer discretionary — almost halved. And utilities, now a tiny part of the Canadian market, lost two-thirds of its market weight.

It would be easy, for example, to deride the health-care sector in Canada. This industry’s subindex has dropped 29% in four years while the energy sector gained 456%. But do we really expect energy will rise at that rate in the next bull market and that health care will continue to drop heavily? So, health care will either disappear or revive.

Much depends on the corporate opportunities, of course. If the companies don’t exist, there will be no investment opportunities in any given sector.

This is a characteristic of most stock markets outside the U.S. — they lack the great diversity found in Wall Street.

Canadian stock market history provides examples of how disappointing, neglected or “forgotten” industries revived to become market leaders:

>Insurance stocks lagged when our stock market rose from its historical low in 1982. They made a half-hearted rally then, but by mid-1984 they had dropped 26% from their rally high. More or less ignored in the new bull market, insurance stocks stirred at that juncture. A year later, they were 71% higher, and two years after the low, they had gained 125%.

>In 1991, food retail stocks went into a tailspin after rising with the market for about 15 years. But after slowly losing 28% of their value, the laggard group started to rally in early 1995.

In mid-1996, after rising 25%, the group took off. Between mid-1996 and 1999, the TSX food-store subindex gained an additional 198%. It eventually rose more than 20 times its price level of 20 years earlier.

>Even though gas and electricity utility stock prices gained in the great bull market of the 1990s, they failed to keep pace. In 1997, they suddenly outperformed the aging bull market but collapsed again in 1999.

After this contradictory performance, gas and electric utilities proceeded to rally through 2000, while most stocks dropped heavily. In two years, the gas and electric utilities index gained 57% while the market dropped 19%.

>Steel stocks stood on the heights in 1969, with the TSX steel subindex near 1200 while the then TSE composite index sat at 890. Jump forward to 2001, when the steel index stood at 730 and the S&P/

TSX composite sat at 6900. Few industries have suffered such a devastating loss in a great bull market and survived.

However, in 2003, steel stocks picked themselves off the floor. They reached a final bottom that was close to their 2001 low. A year later, they were 60% higher; two years later, they had more than doubled from their low. As a result, the TSX steel subindex has risen 328% to the end of March this year from the 2003 low.

Thus, it is from the losers in the past bull market — or bull markets — among which you will find new opportunities.

In the Canadian market, as categorized by the S&P/TSX composite index, many of the 23 industry groups have underperformed over the past three years.

@page_break@This shows up most clearly in the change in their relative strength.

The accompanying table lists 11 such groups, for which relative strength has dropped between 25% and 71% in three years.

Nevertheless, some of these industry subindices trade at fairly high earnings multiples. And some have no earnings at all.

There is no clear trend in subindices with earnings — profits have gained over the past 12 months for some and dropped for others. The picture is similarly mixed for dividend payments.

On the face of it, none of these industries now show a compelling reason to buy them.

Yet, in the next year or so, one or another may perk up, even though the rest of the market may be in disarray.

It is never too early to look for the next winners. ie