Full Circle

A strong rally to start the week yesterday finally brought the S&P 500 all the way back to pre-correction levels. The correction, which began on August 18, resulted in a drop of about 11% to the index’s low of the year on August 25. But that’s all just a distant memory as stocks now seem poised to eclipse the all-time highs posted earlier in the year. We thought it would be instructive to look back at which sectors led the sell-off and the subsequent rebound. Does sector performance over the course of the correction portend further gains in the final weeks of the year? What does the rebound tell us about the current state of the economy?

The correction really just lasted a little over a week. The S&P 500 dropped over 11% from August 17 to August 25. The index then proceeded to bounce sharply only to retest the lows again in late September. Since late September, though, the S&P 500 has enjoyed a steady climb of nearly 12% through yesterday, modestly exceedingly pre-correction levels. Interestingly, the market strength has continued even though the Fed signaled it remains on track to raise interest rates in December. This represents a sea change from the past few years when hawkish Fed commentary was met with the aggressive selling of stocks.

12298682-7967-477d-b345-e27bfea5659cSource: Bloomberg

The table below shows performance by sector from the beginning of the correction on August 17 to the correction low on August 25 (yellow bars). The green bars show sector performance from the beginning of the correction through yesterday’s close (Nov 2). Let’s first discuss the correction. Although no sector was immune to the aggressive selling during the correction, the sectors hit hardest were the ones you would expect. First, those sectors that had performed best over the previous couple of years, Health Care and Info Technology, suffered disproportionate selling. We chalk this up to frothy valuations. Second, the more cyclical sectors, including Energy, Materials and Industrials, were also hit relatively hard. This makes sense since the market selloff was triggered by fears of a significant deceleration in global economic growth. And finally, the Financials sold off hard due to the perception that a slower-growing economy would keep the Fed from raising interest rates this year.

03641796-4803-4f17-9a8d-3e67e07d26c6Source: Bloomberg

The green bars show that half of the ten S&P 500 sectors are currently higher than they were just prior to the correction, while the other half are lower. In general, the winners just keep on winning. The red-hot Consumer Discretionary and Info Technology sectors, which had handily outperformed the overall market since the beginning of 2013, continue to do very well relative to the overall market. In many cases, investors seem loathe to part with their winners, especially when those sales would result in high capital-gains taxes. The one exception is the Health Care sector, which over the past couple of years had benefited greatly from increased numbers of insured under the ACA as well as a number of successful new biotech drugs. Now, however, investors have been spooked by Hillary Clinton’s comments with regard to pharmaceutical price-gouging as well as the Valeant debacle. The cyclical sectors, like Energy and Industrials, are acting a little better, but they remain down significantly on a year-to-date basis. In a nutshell, it’s just hard to draw any firm conclusions about the health of the economy from the recent market action. But there may be one exception.

The Financial sector could be the canary in the coal mine as we look forward to 2016. Interestingly, the Financials continue to underperform despite rising expectations of a Fed interest-rate hike in December. The underperformance reflects the many headwinds that the banks continue to face, including low interest rates, sluggish loan growth, increased regulatory oversight, and lower mortgage originations. Ultimately, the earnings outlook for the banks will only improve if and when interest rates rise and loan growth improves. This can only happen on a sustainable basis when the economy strengthens. So, as of now, the lagging performance of the Financials is one factor that should temper our optimism about the future pace of economic growth.