Market Update
To say the markets have been volatile lately would be the understatement of 2015! This year started out with the major U.S. indices trading in the narrowest range in history, something like Hitch’s (Will Smith) dance instructions for Albert (Kevin James) in the 2005 movie Hitch, if you haven’t seen it you owe to yourself to click here.
The chart below shows how stable the S&P 500 was for the first half of the year, gentle moving back and forth across its 50-day moving average.
Well that all changed… a bit like Albert’s dance moves once he was out on his date with Allegra Cole, and the market started gyrating wildly in ways that would have left Hitch shaking his head.
This chart shows the movement of the S&P 500 starting with the third quarter and ending Wednesday, October 14th. Rather than oscillating gently around its 50-day moving average as was the case during the first half of the year, the index plunged below both its 50-day (yellow line) and 200-day (red line) with the 50-day moving well below the 200-day moving average.
This indicated a material turn in the market’s direction. Recently we’ve seen the markets get all dog-with-waggy-tail about the dour jobs report earlier this month as we return to a bad-news-is-good-news market sentiment. That made a Fed rate hike later this year even less likely which is like giving a triple espresso to your toddler to wash down his Halloween spoils! Early last week the index moved back up above its 50-day moving average, and last week the S&P 500 gave its strongest performance of the year, but that move now appears to possibly have been a failed rally. Market breadth, meaning the number of stocks moving up versus down, continues to have more moving down, which has us concerned that this upward trend is not sustainable.
If we take a bigger step back, we see that the last time the 50-day moving average dropped below the 200-day, was back in August 2011 during the fun times of the government shut-down showdown. That time it took nearly six months for the 50-day to move back above the 200-day with the index declining 19.4% from the April 29th peak to the September 30th 2011 trough.
Thus one of the broadest indices for the U.S. has moved below both its 50-day and 200-day moving averages with its 50-day moving average having moved below its 200-day, indicating the index is in a downtrend. The Russell 2000, which is the standard index for small cap stocks finds itself in the same state of affairs, as does the Nasdaq, the primary technology index – in other words most of the indices are feeling rather peckish.
We also like to look at which sectors are leading the markets as that gives us an indication of market sentiment. Market movement is all about attitudes towards risk. When investors are risk-seeking, the market moves up. When they are risk-averse, it tends to go down. By looking at which sectors are strong and which are weak, we can get a feel for the general attitude towards risk in the markets.
There are two primary classifications for sectors, cyclical and defensive. Defensive sectors are those in which companies tend to not suffer large changes in demand for their products or services during tough economic times. This includes things like basic consumer staples and utilities; people tend to keep buying toilet paper and taking showers even when things aren’t going so well… thankfully. Cyclical sectors are those that enjoy increasing demand during good times, but suffer when families and businesses have to tighten their belts. Companies in the defensive sectors tend to outperform cyclical sectors in downturns and vice versa as investor attitudes towards risk and growth shift.
Healthcare has traditionally been considered a defensive sector, but that has changed in recent years. Since January 1st, 2011 the sector has outperformed every other by a hefty margin, which is not typical defensive sector behavior. This shift is driven by some enormous changes; first, the Affordable Care act significantly increases the demand for healthcare services. Second, aging populations in much of the developed world and China also serve to increase demand. Finally, the percentage of the healthcare sector that is represented by the high-growth biotech sub-industry has grown from a sub-10% weighting in 2001 to nearly 22% today. Conversely, Pharma’s weighting has fallen from more than 70% at year-end 2001 to 42% today, according to Sam Stovall, a U.S. equity strategist at S&P Capital IQ. So despite its defensive heritage, today the sector behaves a bit more cyclically than in years past.
As you can see in the previous chart, for the first half of 2015, the Healthcare (cyclical now) and Consumer Discretionary (cyclical) sectors led by a significant margin, up 10.72% and 7.35% respectively while the Utilities (defensive), Energy (cyclical) and Real Estate (cyclical) sectors lagging the most, down -9.38%, -4.11% and -2.39% respectively.
However, starting July 1st, we see sector leadership shifted with the Utilities (defensive) sector now the strongest performer up nearly 6%, with Real Estate (cyclical) coming in second at 1.7% for the 3+ months while the former leader, Healthcare (cyclical) is now down -10.1%. Financials have also dropped precipitously, down 7.52% and with all the concerns over slowing growth in China, (and with that weaker demand for raw materials) we aren’t surprised to see the materials sector has also dropped to nearly 10% down.
What this tells us is that investors are becoming more risk-averse. The pullback in healthcare is most evident in the iShares Nasdaq Biotechnology ETF which has just experienced a dramatic pullback, down over 20% from its all-time high.
In fact, year-to-date returns have been negative across most every asset class with commodities and emerging markets getting hit hardest, while Japan and Europe have outperformed the U.S., albeit modestly.
Putting it all together, investors have been pulling away from many of those equity sectors and indices that are riskier and moving towards those areas that are viewed as more defensive. In fact, the quarter ending September 30th delivered the worst quarterly stock-market performance since 2011 with the S&P500 falling 6.9% and investors pulling a net of $46 billion out of U.S. stock funds in July and August, according to the Investment Company Institute. Being busy little data beavers, we like to see confirmation of our hypothesis from a variety of sources, so let’s also take a look at bonds.
The next charts show that bonds experienced a similar trend to equities, with a “risk on” environment prevailing in the first half of the year and “risk off” bonds performing better in the third quarter. For example, in the first half, the more “secure” types of bonds, such as domestic investment grade corporate bonds in the iShares iBoxx Investment Grade Corporate Bond fund (LQD) were lagging behind higher risk corporate high-yield bonds/ aka junk bonds like those in the SPDR Barclays High Yield Bond fund (JNK). Even emerging market bonds (high risk) like those in the Vanguard Emerging Market Government Bond ETF (VWOB) and WisdomTree Emerging Markets Corporate Bond (EMCB) were able to outperform longer-dated U.S. Treasury bonds like those in iShares Barclays 20+ Year Treasury bond fund (TLT), but towards the end of the second half things started to shift.
From July first through October 14th, we have seen a substantial reversal of bond sector performance from the first half. For instance, the first half’s worst performer, iShares 20+ Year Treasury bond ETF (TLT) outperformed all other bond funds on the chart in the third quarter’s “risk off” environment. Similarly, lower risk domestic corporate bonds such as those in SPDR Barclays High Yield Bond fund (LQD) significantly outperformed riskier domestic high yield bonds, such as those in SPDR Barclays High Yield Bond fund (JNK) and emerging market corporate bonds such as those in WisdomTree Emerging Market Corporate Bond fund (EMCB) and Vanguard Emerging Market Government Bond Index fund (VWOB).
So far we’ve seen consistent behavior from the various U.S. equity indices and sectors and we have confirmation from bonds that investor sentiment has shifted away from risk. So let’s look around the rest of the world.
Across the globe, markets have all experienced pullbacks, with China’s Shanghai A shares index fell briefly into the red for the year after having risen nearly 60% between January and June and are now up just a little over 3%. France and Italy have performed the strongest year-to-date with their indices up 9.42% and 12.87% respectively. Way to go Italy as it looks like Prime Minister Matteo Renzi’s reforms are being well received by the markets! Germany and Japan managed to be slightly in the green, up 3.07% and 3.95% respectively. With the China’s weakening economy affecting Germany and Japan’s worsening domestic economy, we are on the lookout for more talk of stimulus measures in those areas, which could be a nice tailwind for stock prices.
Finally, the strong dollar, which has been getting a lot of air time over the past year, hasn’t done much either way lately. The next chart shows how it has mostly been sideways since around April of this year, and in fact the AMEX Dollar Index is down -2% since early April and down -0.56% over the past three months. But don’t think that means we are out of the woods just yet as we are already getting warnings from a variety of companies across a wide swath of industries that their earnings (earnings season is just kicking off) will be weaker than expected in part due to the strong dollar.
You’ll notice on the next chart that the dollar hit a trough the day the markets had a major correction, on August 24th and again the day the Fed announced that it would not be raising rates. Pardon a brief little pat on the back as I’ve been calling that one since May. With the data we were seeing, a rate hike looked nigh impossible, despite the proclamations by many on Wall Street that it was a fait accompli.
