Watch What You Wish For!

It’s now been over a year and a half since the S&P 500 sustained a correction of at least 10%. The last correction ended 552 days ago on February 11, 2016. But as we discussed in our March 30th Market Commentary (“Is a Correction Coming?”) earlier this year, the long slog higher in the S&P 500 has not come without some internal discomfort. At that time we wrote that six of the S&P 500 industry sectors had sustained corrections of 10% or more during the course of the broader-market rally. However, the weakness in those sectors was more than offset by strength in other sectors, producing a very nice outcome of steady S&P 500 gains with very limited volatility. In team golf we call this a “ham and eggs” approach – as long as my partner is making good shots, it doesn’t matter that I can’t hit the broad side of a barn!

Now that the S&P 500 has continued its ascent (with even less volatility) for another four and a half months, we thought we’d take another look at internal performance. The chart below shows all the sector corrections since the end of the last S&P 500 correction. The first thing to note is that the correction in the Energy sector, which we identified in our March 30 Market Commentary, continues uninterrupted as the price of oil swings widely but remains well below the $54-$58 range of very early in the year. In fact, the correction in Energy-sector stocks, now over eight months in duration, is very close to qualifying as a “bear market” (drop of > 20%). Remarkably, the S&P 500 Energy sector has shed over 18% of its value since mid-December even as the S&P 500 has increased about 8.5%. Given the decline, the Energy sector is far less influential than it once was. Energy now accounts for just 5.7% of the total S&P 500 (by market capitalization) compared to about 7.5% prior to its correction and compared to about 13.3% at the end of 2008. And the sector’s correction may not be over yet!

Second, we discovered the Telecom sector has sustained a second distinct correction since we last ran these numbers. The volatility in this sector is highly unusual as it is generally viewed as one of the more stable sources of dividend income. However, the relative volatility among not only Telecom, but also Utilities, Real Estate and Consumer Staples, shows how tethered much of the market has become to low interest rates. Following eight years of artificially low interest rates, investors will shed stocks in these sectors if and when interest rates begin to rise in earnest.

One sector that should benefit from higher interest rates is the Financials sectors. In the chart below, we decided to flag a 9% drop in the Financials sector even though it doesn’t technically qualify as a correction. This “pullback” occurred in response to a sharp decline in interest rates over that time frame. The yield on the 10-year Treasury fell from about 2.63% to about 2.17% in a little over a month. The sector has since recovered nearly all of that lost ground even as interest rates remain low.

Source: Standard & Poor’s

What is our takeaway from this analysis? The first thing that comes to mind is that many investors have lost big money betting on losing sectors even as the overall market has continued steadily higher. Secondly, these “rolling corrections” in different industries have created opportunities to buy quality companies at reasonable prices. But most important of all is this: Trends that are positive for stock performance within certain sectors may not necessarily be good for other sectors, corporate earnings at large, consumer health, economic growth, and the stock market at large. Consider the following:

  • Higher interest rates will be positive for bank earnings and stock prices, but how will meaningfully higher interest rates affect an economy that has become addicted to ultra-low interest rates?
  • Will higher interest rates cause a rotation out of stocks (especially stocks with high dividend yields) and into bonds, money market accounts, CDs, etc? Will banks suddenly lose an abundant source of ultra-low cost deposits?
  • If stock prices do suffer from an investor rotation, will this cause a negative wealth effect or will higher interest income offset the drop in stock prices?
  • Higher energy prices are positive for energy stocks, but what effect would higher energy costs have on the consumer spending?
  • Most economists believe wage growth is the missing element in this economic recovery (and we agree), but how will wage inflation affect corporate margins, profitability and stock prices?
  • A significant drop in the dollar is currently supporting sales and earnings for US multinational corporations. Will the reversal of this trend (perhaps due to rising interest rates and accelerating economic growth) have a significant impact on exports and US multinational earnings and stock prices?
  • Falling rates of inflation have held back sales and earnings in a number of industry sectors (Industrials, Consumer Staples, Materials, Energy), but will a resurgence in inflation cause the Fed to increase the pace of interest-rate hikes?

As you can see, there is a lot to think about. Trends are rarely unambiguously good or bad. It is important to always remember that consumer spending represents over two-thirds of the US economy. Consumer spending has been heavily supported by ultra-low interest rates and energy prices for the past many years. Nobody is quite sure how a reversal in these long-term, stimulative forces will affect consumer health and the economy at large. So be careful what you wish for.