Leadership Change, In More Ways Than One

Posted on Nov 25, 2020 in Investment Strategy

Leadership Change, In More Ways Than One

In last week’s Market Commentary, I talked about the fact that the market value of the S&P 500, at about 21.7x the consensus earnings estimate for 2021, has rarely been so rich over the past 20 years. I said that the stock market could be at risk for a correction if the market is unable to maintain such a lofty premium valuation going forward. I also said that analysts’ earnings estimates for the next two years incorporate some healthy growth rates that may or may not come to fruition. The failure to hit those targets is another source of risk for stock market investors in the year to come.

In today’s Market Commentary, I wanted to strike a more optimistic chord by following up on my Market Commentary from November 12th. In that piece I suggested that investors, faced with high market valuations, may find more opportunity in those sectors and stocks that have been lagging for a long time. I suggested that strength in the beaten-down Industrials, Financials and Energy stocks, in particular, could lay the foundation for next leg up for the overall market, should that scenario come to pass.

In the first chart below, I show the performance of five S&P 500 industry sectors, beginning with an initial value of 100 for each at the beginning of 2018. You will see that the sectors that I refer to as the laggards (Financials, Energy and Industrials) have indeed experienced a spike in recent weeks (gray shaded area). However, the recent spike follows a period of dramatic underperformance for all three sectors, each of which is generally perceived to be highly sensitive to the economic backdrop. You will notice that until up until mid-2020, all three sectors had traded below the levels of early 2018. At the same time, the Technology and Consumer Discretionary sectors have dramatically outperformed over the three-year period while also holding their own in recent weeks. It is important to note that the strength in the Consumer Discretionary sector is due, in large part, to the inclusion of Amazon in that sector (rather than in the Technology sector).

In the next chart, I show that the combined weighting of the three laggard sectors has dropped from 31.1% at the end of 2017 to 22.1% today. That means that the remaining eight sectors increased in importance from 68.9% to 77.9% in less than 3 years. That’s a pretty sizeable rotation, but nothing close to anomalous. Sector weightings tend to bounce around a lot, but the relentless rise in technology stocks (especially the FAANGs) over the past few years has been particularly noteworthy. My view is that the leadership will have to change if the bull market is to continue.

Will the rally continue? There’s no way to say for sure, but if so it would be reasonable to expect continued strength in the economically sensitive laggards. Now that we have promising vaccine candidates and election closure, we may be drawing closer to a more definitive market rotation.

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