And What If The Broad Equity Market Remains Range-Bound?
We hear the calls of the Bulls predicting an S&P 500 above 3200 by year-end and the index at some 4000+ in 2020. On the other side of the debate, bears have been citing lots of legitimate reasons why stocks should come down. But the reality is that no force is strong enough to break the “Fed put” supporting the markets. Perhaps neither Bulls nor Bears will be correct, at least in the short-to-intermediate term.
One scenario that we are entertaining is a repeat of the sideways equity market in 2015. Why? We see several parallels. First, 2013 saw a monster rally that required over two years to digest between 2014 to 2016. Similarly, we got a monster rally from 2016 to January 2018 that may also need a couple of years of sideways price action to digest the linear price appreciation. In reality, since 2018, the NYSE Composite Index has been in a sideways trading range (except for the December 2018 sell-off) than a trending bull market.
Another parallel between the 2015 market and today is the “friendly Fed” equity buying. In 2013, investors went bonkers on free money from the Fed and Ben Bernanke’s “QE Forever.” Once the giddiness of having a friendly Fed got fully known by all market participants, prices leveled off starting in 2014. In 2019, we also saw a transition from a hostile, rate-hiking Fed to a renewed accommodative Fed. After three rate cuts in 2019 and a promise to never raise rates again (barring the unlikely event of seeing inflation hold above 2% for an extended period), most everyone is now aware that “the Fed has our backs” once again.
More generally, we feel that equity markets have pulled forward lots of good news. Equities are rising on hopes of a resolution to the trade war, on the belief that the slowdown in the manufacturing sector has passed, and on persistently optimistic earnings outlooks. However, equity indexes may stall until the earnings growth story for next year gets bought into in earnest. Remember, for almost each year in this expansion, earnings forecasts have started the year high and get revised down as the year progresses.
Should the sideways S&P 500 seen in 2015 play out again (see chart above), investors’ best hope to produce portfolio returns will be through correctly identifying sectors remaining in uptrends while avoiding the relative underperformers. Indeed, we can envision rolling bear markets within S&P sectors, like in 2014-2016, as the broad market continues to digest steep gains in equities since Trump’s election. There appears, at the moment, to be no reason for longer-term investors to take money out of equities. As over-extended and crowded trades start to underperform, we expect that investors will “catch on” and move progressively into lagging sectors (or just remain in sectors able to maintain a relative uptrend).
To illustrate how we envision the next months playing out, we look back at the 2014-2016 period when several sectors experienced full bear markets (over -20% drops), even as the S&P only fell -13% peak-to-trough in this period.
The small caps were one asset classes that investors would have been better off avoiding in 2014-2016. The blue line measures the relative performance of small caps to the S&P 500. It was apparent that the relative price trend was making lower highs and lower lows even well before the -26% draw-down began in the Russell 2000 index (red line).
The S&P Energy Index was another asset class that suffered a bear market in the 2014-2016 period. Unlike the small caps above, the relative trend line in blue (Energy/S&P 500) did not foreshadow the weakness in the Energy index, as both the absolute and relative price curves fell concomitantly.
The Retailers also had a nasty drop in 2015. Like with small caps, the relative underperformance of retail could have been used as a sign of impending trouble in the sector.
The Dow Transports came through 2014 nicely, but the trouble for this sector began right away in 2015. Again, relative to the S&P 500 (blue line), we see relative underperformance of Transports setting up well before the capitulation selling began on the Dow Transports Index (in red) in November 2015.
Finally, the S&P Banks suffered a bear market in the 2014-2016 period. As the theme here is rolling sector bear markets which smoothed out the draw-down in the S&P 500 itself, we note that the bear market in the banks did not hit until 2016, just as the above sectors were already rallying back. And once again, we observed the relative underperformance of the S&P Bank index (blue line) well in advance of the major drop in the index (red line).
What did work in 2014-2016 were Consumer Staples and Technology. The relative price curves for these two sectors remained in clear uptrends throughout the period.
Fast forward to 2019. There is much debate among market analysts over whether investors should stick with growth or, at long last, move back into value stocks, such as banks and energy. While this may not be profound advice, the lesson to take away from the 2015 rolling bear market period is to follow the trend in relative strength. Sectors that maintain relative uptrends are less likely to see major drawdowns in the absolute market price of the sector index.
We went through the major U.S. equity asset classes and charted their relative performances since January 2018. The divergences are rather large, as shown below.
Sitting in anything Technology-related has been the slam dunk trade. The presence of Utilities may seem curious, but Utilities have been getting a bid from traditional bond investors looking for equity bond proxies.
Given that the S&P 500 is close to 200 points higher today from the average price level in January 2018, it is surprising to see so many sectors underperform. As we recently wrote about in Not Trusting The A/D Line, we have observed a stark divergence between the S&P 500 Market Cap Index (the one everyone follows) and the S&P 500 Equal Weight Index. To put it simply, the divergence is due to the extra weight in Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Facebook (NASDAQ:FB), and Intel (NASDAQ:INTC) in the S&P 500 Market Cap Index. As such, we can have broad sector-level weakness concomitant with a strong S&P 500.
Two sectors, Staples and Health Care, are pretty close to unchanged over the past 18 months or so.
And two sectors, Energy and Metals & Mining, have (continued) to fall out of bed.
Our takeaways for investing going forward:
- Stay with relative outperforming sectors (the trend is your friend) but remain alert to weakening relative strength.
As long as interest rates are rising in the U.S., the interest-rate sensitive sectors like Utilities and Real Estate could be at risk.
- Banks underperformed for most of the period since January 2018, but the steepening yield curve today could allow us to remove Banks from the underperformers list. Banks are one “less” crowded trade that may see money rotate in.
- We are not convinced that the value trade will boost Energy. If the trend is your friend, the relative downtrend in Energy reminds us that rallies are likely to be sold.
Respect the 2015 paradigm – avoid bottom picking in sectors in relative downtrends.