Stocks Take A Bullish Rotation Into Neglected Market Segments, But Will It Last?

In case you didn’t notice, the past several days have brought an exciting and promising change in character in the US stock market. Capital has been rotating out of the investor darlings – including the momentum, growth, and low-volatility factors, as well as Treasury bonds and “bond proxy” defensive sectors – and into the neglected market segments like value, small-mid caps, and cyclical sectors favored by Sabrient’s GARP (growth at a reasonable price) model, many of which have languished with low valuations despite solid forward growth expectations. And it came just in the nick of time.

In Q3 of last year, the S&P 500 was hitting new highs and the financial press was claiming that investors were ignoring the trade war, when in fact they weren’t ignoring it at all, as evidenced by narrow leadership coming primarily from the mega-cap secular Technology names and large-cap defensive sectors (risk-off). In reality, such market behavior was unhealthy and doomed to failure without a broadening into higher-beta cyclical sectors and small-mid caps, which is what I was opining about at the time. Of course, you know what happened, as Q4 brought about an ugly selloff. And this year, Q3 was looking much the same – at least until this sudden shift in investor preferences.

Last month, as has become expected given its typically low-volume summer trading, August saw increased volatility – and also brought out apocalyptic commentaries similar to what we heard from the talking heads in December. In contrast to the severely overbought technical conditions in July when the S&P 500 managed to make a new high, August saw the opposite, with the major indices becoming severely oversold and either challenging or losing support at their 200-day moving averages or even testing their May lows, as investors grew increasingly concerned about a protracted trade war, intensifying protectionist rhetoric, geopolitical turmoil, Hard Brexit, slowing global economy, and US corporate earnings recession. Utilities and Real Estate led, while Energy trailed. Bonds surged and yields plunged. August was the worst month for value stocks in over 20 years.

But alas, it appears it we may have seen a blow-off top in bonds, and Treasury yields may have put in a bottom. All of a sudden, the major topic of conversation among the talking heads this week has been the dramatic rotation from risk-off market segments to risk-on, which has been a boon for Sabrient’s Baker’s Dozen portfolios, giving them the opportunity to gain a lot of ground versus the S&P 500 benchmark. The Energy sector had been a persistent laggard, but the shorts have been covering as oil prices have firmed up. Financials have caught a bid as US Treasury prices have fallen (and yields have risen). Small-cap value has been greatly outperforming large-cap growth. It seems investors are suddenly less worried about a 2020 recession, ostensibly due to renewed optimism about trade talks, or perhaps due to the apparent resilience of our economy to weather the storm.

The question, though, is whether this is just a temporary reversion to the mean – aka a “junk rally,” as some have postulated – or if it is the start of a healthy broadening in the market and a rotation from the larger, high-quality but high-priced stocks (which have been bid up by overly cautious sentiment, passive index investing, and algorithmic trading, in my view), into the promising earnings growers, cyclicals, and good-quality mid and small caps that would normally lead a rising market. After all, despite its strong year-to-date performance, the S&P 500 really hasn’t progressed much at all from last September’s high. But a real breakout finally may be in store if this risk-on rotation can continue.

I think the market is at a critical turning point. We may be seeing a tacit acknowledgment among investors that perhaps the economy is likely to hold up despite the trade war. And perhaps mega-caps with a lot of international exposure are no longer the best place to invest. And perhaps those mega-caps, along with the defensive sectors that have been leading the market for so long, are largely bid up and played out at this point such that the more attractive opportunities now lie in the unjustly neglected areas – many of which still trade at single-digit forward P/Es despite solid growth expectations.

September is historically a bad month for stocks. It is the only month in which the Dow Jones Industrials index has averaged negative performance over the past 100 years, showing positive returns about 40% of the time (according to Bespoke Investment Group). But this budding rotation may be setting up a more positive outcome. I was on the verge of publishing this month’s article early last week, but the market’s sudden (and important!) change in character led me to hold off for a few days to see how the action unfolded, and I have taken a new tack on my content.

In this periodic update, I provide a detailed market commentary, offer my technical analysis of the S&P 500, review Sabrient’s latest fundamentals-based SectorCast rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. In summary, our sector rankings look defensive to me, while the technical picture is short-term overbought but longer-term bullish, and the sector rotation model takes to a solidly bullish posture.

Market Commentary:

I’d like to welcome my readers back after what was hopefully a pleasant summer. I know that many of you were impacted by severe weather events and I hope you and your friends and loved ones came through in good shape. Please know that when I see these things in the news, whether in Florida or South Dakota or wherever they may be, I am thinking of you and wishing the best for you. For my part, although I now live in Scottsdale (and work out of Gradient Analytics’ Phoenix office), my wife Laura and I escaped the heat by spending the month of August living and working in the Ventura/Santa Barbara area where Sabrient is based. 40 degrees cooler was quite pleasant.

Sorry if I am even more long-winded this month than usual, but the past week’s sudden turn of events has given me a lot to talk about.

The fledgling risk-on rotation:

Starting with my July 2018 article, I have been consistently writing about the market bifurcation that began in mid-June 2018 – driven by a stark escalation in the trade war with China and an “autopilot” Federal Reserve – leading to defensive sectors, low-volatility, “bond proxies,” and secular-growth big-cap Tech getting the capital flows at the expense of the typical market segments that lead in a strong economy, like cyclical sectors (Financials, Industrials, Energy, Materials), small-mid caps, and high-beta. And even as the S&P 500 hit new highs this summer, S&P Global has termed it a “low conviction rally” led by Minimum Volatility and Low Volatility (i.e., risk-off) factors, opining that the significant outperformance of the S&P 500 Low Volatility Index (SPLV) versus the S&P 500 Index is “unusually strong performance for a defensive index in a rising market.” And while large cap indexes continued to hit new highs through July, the S&P 600 small cap index has remained at least 10% below its high from August 2018.

This piece from First Trust illustrates the extreme relative outperformance of large caps and defensive sectors during the roughly 18 months spanning 3/8/18-8/26/19, in which there were really only about three months in which cyclicals and small caps provided leadership (mostly during the post-meltdown rally 12/24/18-3/1/19). And over the past year (ever since small caps peaked on 8/31/18 through 8/31/19), small cap value trailed large cap growth by more than 20 percentage points (pps). Moreover, as Simeon Hyman of ProShares noted in his latest market commentary, the relative valuation of US small caps versus large caps actually has been steadily declining for the past 10 years, with the aggregate price-to-book (P/B) ratio for small caps having fallen from near parity with large caps to a 40% discount today. One would think that falling interest rates would benefit small caps given their typically higher leverage.

The top four sector ETFs for asset flows for most of this year have been Real Estate, Telecom, Utilities, and Consumer Staples, which all serve as “bond proxies” given their attractive dividend yields. As a result, the forward P/E on the low-growth Utilities Select SPDR (XLU) was at 18.9x heading into September while the higher-growth Energy Select SPDR (XLE) languished at 15.5x, and the broad S&P 500 was at 16.5x. This was not indicative of a healthy stock market.

Although the market’s YTD performance looks really good – with the S&P 500 total return an impressive +21.6% while the Russell 2000 is up +18.2% as of 9/13/19 – much of it simply has been recovering ground that was lost during 4Q18. Once the S&P 500 hit its 2018 peak on 9/20/18, it has really only gone sideways ever since, with a few failed attempts to break out to the upside. It couldn’t achieve a new high until July, and even now on this latest breakout attempt is only about 2.6% above that previous high, while the Russell 2000 is still nearly 10% below its 8/31/18 high.

Last September, I opined that the market would not be able to progress much higher without a rotation back into risk-on market segments, and I have felt the same way this year. This all has been hard on Sabrient’s GARP portfolios, including our monthly Baker’s Dozens. But our model-driven approach has consistently indicated to us that those “risk-on” market segments showed little in the way of reduced forward guidance, and so their forward valuations (e.g., P/E and PEG ratios) kept falling (i.e., even more attractive) as share prices fell while earnings expectations held up, reflecting cautious investor sentiment and an apparent belief that things were bound to take a turn for the worse. Eventually, the trade war’s impact on the psyche of corporate leaders indeed began to bring down forward guidance, as capital investment was put on hold, even though consumer sentiment has remained robust and the driver of solid economic growth while the manufacturing segment has fallen into contraction.

But despite the persistent risk-off sentiment, an underlying strength and optimism in our economy has remained intact, bolstered by the Fed’s dovish reversal on monetary policy, such that every time there are signs of optimism about trade negotiations, investors have shown a readiness for that risk-on rotation. In fact, much of the leadership during the initial post-selloff recovery (12/24/18-3/1/19) was provided by the risk-on market segments, and so far, they are driving this latest breakout attempt. Indeed, we finally might be getting a sustained rotation, and everyone seems to be talking about the market’s sudden change of character.

The chart below illustrates September’s dramatic rotation from the investor darlings from momentum, growth, low-volatility defensive sectors, and Treasury bonds, and into the long-neglected risk-on market segments like value, high beta, small-mid caps, and cyclical sectors. Note the approximate +7 percentage points (pps) outperformance of SPDR S&P 600 Small Cap Value (SLYV), up +9%, versus SPDR S&P 500 Growth (SPYG), up less than +2%, in just the first two weeks of September. Also shown for comparisons are the Invesco S&P 500 High Beta (SPHB) outperforming both the Invesco S&P 500 Low Volatility (SPLV) and iShares Edge MSCI USA Momentum (MTUM) by about 7 and 8 pps, respectively. And here is another interesting comparison not shown on the chart: Over the same timeframe, the highly cyclical VanEck Vectors Steel ETF (SLX) is up +14% while the iShares 20+ Year Treasury Bond ETF (TLT) is down about -7% – a performance gap of +21 pps in two weeks! This promising turn in investor preferences has helped Sabrient’s portfolios gain significant ground against the SPY benchmark.

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Disclosure: At the time of this writing, the author held both long and short options on the SPY and IWM (long-term bullish, short-term bearish) and a short position on the ...

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