Everyday, Everyday I Have the Blues
By John Stoltzfus,
Chief Investment Strategist
Trend Analysis
Market Strategy Radar Screen Weekly October 24, 2016
In this article:
- Small and mid cap stocks while considered by many investors to be among the most sensitive to economic growth as well as less sensitive to dollar strength are often overlooked by others in the investment community even as M&A activity often favors them.
Don't Change Horses in the Middle of the Stream
Beyond the equity market's current "ponder" and rotation, we expect to be rewarded
What’s the market telling investors? Is the Bull “tired” as some say or is it waiting for a catalyst to appear on the scene to make its next decisive move? Without hesitation we think it is the latter.
With the US Presidential election just 15 days away and the Federal Reserve’s December FOMC meeting only 51 days away it appears to us that the market is biding its time until it can put the outcome of the two aforementioned sources of uncertainty behind it.
For now the market appears to be biding its time in a process of rotation from defensive stocks (particularly those considered “bond proxies”) into cyclical stocks—companies that are more sensitive to economic growth and those that are often considered better able to navigate an increase in interest rates.
The thought is that when the Fed raises rates the act of moving rates higher can be taken as confirmation that the central bank believes the economy is strong enough for the Fed to pursue its process of interest rate normalization without derailing the economy or the markets. That is, so long as policy makers don’t hike them in large increments, too frequently, or ultimately too high.
So far the market’s transition from overweighting defensives to overweighting cyclicals has been remarkably smooth even as it creates somewhat of a churning sensation.
So far this year
The first half of the year (1Q and 2Q) was led by defensive sectors made up of stocks which often serve as bond proxies. The Telecom services and Utilities sectors of the S&P 500 rose 21.8% and 21.2% respectively in the first half of the year.
Driving those sectors higher in the first six months of the year in no small part was investors’ demand for investments that could provide current income as bond yields fell further than many had expected.
With the third quarter came expectations among some investors that bond yields had fallen about as far as they could go. Concerns were also rising that the Fed was nearing a rate hike based on improving economic data and increasingly hawkish “Fedspeak” (comments by Fed officials).
At least some investors who had earlier diversified their income-generating holdings into bond proxy stocks (traditionally defensive sectors including telecom, utilities and consumer staples) took some profits in those positions from the first half of the year and rotated the proceeds into cyclical sectors, among which there are also many dividend-paying stocks (thus providing income).
From the start of the third quarter to the start of the fourth quarter the telecom services and utilities sectors moved from being the first and second best performing sectors in the first half of the year to become the worst-performing sectors in 3Q, falling respectively 6.6% and 6.7% between June 30th and September 30th.
As the two leading sectors from the first half moved to the bottom of the S&P 500 sector performance rankings, technology and financials, which had been the worst performers (off respectively 1.17% and 4.6% in the first half), rallied to become the top performers rising respectively 12.44% and 4.03% in 3Q.
Since the start of the fourth quarter as the rotation is digested by the market, the few remaining weeks to Election Day and the Fed’s FOMC meeting have increasingly garnered investors’ attention and even concern.
Even as earnings declines in the energy sector remain a drag on overall results, other sectors have been posting positive results that are above expectations (see the earnings score card on page 4 of this report for greater detail).
While the S&P 500 often takes up greater mind share among investors, we find it worth noting that the mid-caps (the S&P 400) and small cap stocks (as tracked by the S&P 600) have outperformed the S&P 500 in the first half of the year (rising 7.0% and 5.45% respectively in 1H vs. the S&P 500’s gain of 2.7%); and in the third quarter (rising 3.73% and 6.9% respectively vs. the S&P 500’s gain of 3.3% in the same period).
Small caps and mid cap stocks while considered by many investors to be among the most sensitive to economic growth as well as less sensitive to dollar strength are often overlooked by others in the investment community even as M&A activity often favors them.
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