Vicious Sector Rotation —Will The Weak Inherit This Market?

 In Strategy Updates

For those of us that watch financial markets closely, the past six weeks have been stunning. Stock indexes have made a swift and vigorous attempt to gain back previous losses — similar to what we witnessed at year’s end. More importantly, the stocks that have lead this strength are those that have been the most punished over the past year including energy, industrial and material companies whose profitability in past quarters has all but evaporated. What does this mean for the health of today’s stock market and global economy? We have some thoughts.

Though recent strength in stock prices is a relief, it is hardly a sign that we are in a new bull market. We need better economic data and better corporate profits to confirm that the recent strength is more than a “bear trap” — a rally that feels good but fails to last and then returns to prior lows (such as we saw just 6 weeks ago). Recent corporate earnings reports have been ugly, with declining profits in nearly every sector with the exception of healthcare, consumer staples and utility companies — those sectors that are immune to economic weakness and where your portfolio has been overweighted. For all intents and purposes, we are in a very real earnings recession, if not an overall economic recession. Though many stocks have rallied strongly recently, they remain far below their high levels of the summer of 2015.

The recent and significant strength of the energy, material and industrial stocks is very interesting as each of these sectors benefit from a stronger economy. Is the market telling us that economic growth in future quarters is likely to strengthen? Perhaps. Or can the recent strength in these sectors merely be attributed to “short covering” by hedge funds who are buying back shares previously sold or by deep value investors who have finally gathered the courage to dive in? We think the answer to this question lies in the next imminent correction in stock indexes.

Every big rally in stocks eventually succumbs to a pull back — what we call a correction. Since the summer of 2015, each of these declines has brought stocks in most sectors to new lows — to the dismay of most investors. We believe that this next pull back in stocks and corresponding economic data points will be very telling about the health of the economy and global stock markets. If in the next correction stocks can hold above the lows of February — particularly the energy, industrial and material sectors — it may be that this difficult period will go down as a gentle “teddy bear” market. This would be a sign that we could get back to investing in a less defensive manner. On the other hand, any decline that gets close to the previous market lows and drags the recent strong sectors down with it would mean that we are likely in for further market volatility. At this point, it is impossible to know which way this will turn out so we will continue to err on the side of caution with your portfolio and stand ready for either alternative.

At some point the market “funk” of recent quarters will end — we speculate sometime in the third quarter at the latest. At that time, the election will be less of a mystery and the earnings recession will most likely have abated. We have been busy making a list of great companies to add to your portfolio when the time is right.

In the meantime, we await the next correction in stock prices — should it be more significant than normal, we will continue to manage your portfolio’s risk through your asset allocation, sector management and carefully placed stop loss orders. For the non-stock portion of your portfolio we continue to seek and purchase investments that will provide yield better than money market funds: bonds (when we can find good value), REITs (real estate investment trusts), preferred stock and utility companies, none of which have the volatility of the stock market.

The past eight months of market turmoil have been challenging but, like all things, this will eventually be resolved. If you have any questions about your portfolio or have experienced any significant changes in your financial circumstance, please let us know.

Sincerely,

Your Team at Main Street Research