For many months we have been forecasting a rotation from highly cyclical, more speculative stocks into higher-quality and more defensive blue chip stocks. This rotation seems to be continuing. We went back and looked at the performance of the ten industry sectors within the S&P 500 over the past two and a half months. The start date was July 22, which was the beginning of the market sell-off. Below we show the results of our analysis. The highly cyclical sectors, including Materials, Energy, Financials and Industrials, were the worst performing sectors during the period. The more defensive sectors, which generally offer more earnings stability and higher dividend yields, performed the best. These sectors included Utilities, Consumer Staples, Telecom, Information Technology, and Health Care.
Consumer Staples -6.9%
Info Tech -12.6%
Health Care -12.6%
Consumer Discretionary -15.0%
S&P 500 -16.4%
We also wanted to look at the relative performance of small-cap stocks versus the larger stocks represented in the S&P 500. The Russell 2000 Index is the most widely used proxy for small-cap performance. As the chart below shows, the large-cap stocks within the S&P 500 have handily outperformed the Russell 2000 since the sell-off began on July 22. In fact, the Russell 2000 is down nearly 23% compared to the 16.4% decline in the S&P 500.
What does this all mean? It means that investors seem to finally be recognizing and appreciating the economic challenges we are facing. Just as money has poured into the US dollar and US Treasuries, equity portfolio managers (and many retail investors) are rotating into those companies that have the financial strength to withstand a period of sub-standard global and domestic economic growth. Large US multinational companies, heavily represented in the S&P 500, have relatively low debt and are carrying record amounts of cash. Unlike their smaller counterparts, they generate their funding needs internally and should be less reliant on bank funding and the capital markets. In addition, the large companies in the S&P 500, on average, pay a 2.3% dividend yield. This yield is very attractive compared to the sub-2% available from the 10-year Treasury bond and compares favorably to the 1.8% paid (on average) by Russell 2000 companies. And finally, large and defensive blue chips are very attractively valued relative to smaller and more speculative and cyclical companies.
We remain defensive but fully invested in the large and defensive companies described above. We would expect the recent outperformance to continue as the developed economies continue through the process of deleveraging. This process could take many quarters, but there is value in the types of companies we favor.