Rotations Afoot?

It started early last week, and the trend continued on Monday. An abrupt sell-off in market-leading Technology stocks coincided with meaningful gains in the Financials and Consumer Discretionary sectors. In one week, the S&P Technology sector lost a little over 4% of its value, while the Consumer sectors each gained similar amounts; financials increased an impressive 7%. The proximate cause for this rotation was Congressional progress on the tax bill. The rationale is that lower corporate tax rates in the US will most benefit those companies that operate largely within US borders. Which sectors are heavily weighted to the US? At the top of the list are the Financials sector, which includes not only global money center banks but also many domestic-oriented regional banks, brokerages and insurance companies, and the Consumer Discretionary sector, which is largely comprised of domestically focused retail chains and media companies. If and when the tax reform bill is passed, most of the companies in these sectors should benefit from a positive shift in after-tax profit margins. The stocks are moving in anticipation of that shift.

The Financials sector further benefited from the Congressional testimony of Fed Chair nominee Jerome Powell. Mr. Powell signaled his support for the gradual removal of policy stimulus (ie he will continue the Fed’s path begun this year with gradual interest-rate increases), but perhaps more importantly he signaled his willingness to reduce regulatory burdens on banks (especially smaller ones). Hopes for a powerful combination of higher interest rates, lower tax rates and a reduced regulatory burden have produced an 8% increase in the KBW Bank index over the past week.

The Consumer Discretionary sector, for its part, appears to be emerging from a cloud of negativity created by industry disrupter Amazon.com. Over the course of the past year we witnessed individual companies and sub-sectors within retail suffer dramatic corrections just on rumors of increasing competitive interest from Amazon. Now that the Amazon concerns have subsided somewhat, we are seeing a wave of new interest in many Consumer Discretionary stocks. Add to that a strong holiday shopping season, the real possibility of big tax cuts being enacted, and the bump of short-sellers abandoning their positions on trend reversal, and you have a recipe for a rally.

Source: Bloomberg

Concurrent with the trend into consumer and financial stocks, there is a broader rotation taking place out of Growth and into Value. Incredibly, the Russell 1000 Growth index had outperformed the Russell 1000 Value index by 20 percentage points (26.5% versus 6.5%) for the year through November 27. In just five trading days since that date, though, the Value index picked up significant ground, and as of this Monday, December 4, was trailing by only 16%. The important thing to note about the Growth index is that it has been driven higher by a handful of highly influential names. The FANG stocks have dominated the scene for growth-oriented investors this year and for quite some time. However, since their peak on November 28, the FANG stocks (we include Facebook, Alphabet, Amazon, Netflix, Apple and Microsoft) collectively lost an estimated $127 billion in market capitalization through Monday. That is a fairly stunning figure. What is more stunning, though, is that even with last week’s losses, these stocks are still up 43% on average for the year. It seems to reason that if the current rotation continues, there could be a lot more pain for those heavily invested in yesterday’s darlings.

Source: Bloomberg

We want you to be aware of a powerful rotation that has been going on over the past week. While Tuesday the technology sector was the only sector in positive territory for the day, trend lines never follow a straight line. Nonetheless there is a LOT more room for this rotation to continue. The high-growth and large-capitalization FANG stocks have provided much of the impetus for the rise in the major indices for years, but especially this year. Generally speaking, these types of high-growth companies are more valuable in a low interest-rate environment because their cash flows (to investors) are not expected to materialize until several years in the future. Investors in lower-growth value stocks, by contrast, see much of their investment return through dividends. As a result, rising interest rates can very often cause this sort of rotation out of growth stocks and into value stocks. There is somewhat of an offset because bonds become a more attractive alternative to value stocks as interest rates rise. We shall see in the coming months which is the larger force. Until then, buckle down!