In a mid-March note, we advocated for boosting cyclically-oriented global equity exposure at the expense of defensive global equities. Specifically we favored reducing Utilities ($JXI), Consumer Staples ($KXI) and Telecom Services ($IXJ), in favor of Information Technology ($IXN) and Health Care ($IXJ). As of the time of this writing, each of the aforementioned sector funds have lagged $ACWI (Utilities by 49 bps, Consumer Staples by 67 bps and Telecom by 291 bps).
Also consistent with our expectations, Health Care has beat the market by 149 bps over the last two and a half months, and the relative uptrend still exhibits signs of life. On the other hand, our optimistic call on technology looks to have been a miss, as $IXN has lagged our proxy for global equities by 17 bps since our March 14 piece.
All in all our call added value, especially the reduction of Telecom and Staples and the addition to Health Care. A comparison of the performance of the Russell 3000 Dynamic Index with the Russell 3000 Defensives Index (our favorite gauge for cyclicals vs. defensives at the broad market level) over the life of the trade offers one means of quantifying this impact. The lower pane of the first exhibit (below) shows the relative performance of these indices since March 14. Per this measure, cyclicals enjoyed a 149 bps advantage over defensives.
(All relative performance figures cited above exclude dividends).
Lately, we have observed indications that the medium-term rotation away from defensives and toward cyclicals is near an end. In fact, in some cases, the changing of the equity market guard looks to be in process already.
In support of our burgeoning defensive equity bias, the following chart indicates our momentum model’s sector-level expectations for medium-term (i.e. two to three months) over- and underperformance relative to the broad equity market.
Recall that we regard relative performance as cyclical. Accordingly, we assume that bouts of leadership follow spates of sub-par returns, and vice-versa. And while we admit that the sine curve featured above is an overly simplistic representation of the momentum cycle, because peaks and valleys in relative momentum rarely unfold symmetrically with regard to time or magnitude), we find that the approach does allow us to convey our perspective graphically, in an easy-to-grasp manner.
Our view for any market cohort (in this case, sector) at any specific point in time can be surmised by its position on the curve. Points placed on the rising portion of the curve are expected to lead the broad equities market in weeks to come, while the reverse is true for points on the downward-sloping part of the curve. Ideally, one would buy segments of the market situated around the trough of the curve, as this condition represents bottoming medium-term relative momentum and is expected to foreshadow the longest stints outperformance to come, and sell areas at the curve’s peak.
Note in Exhibit 2 that that global cyclical sectors such as Materials, Industrials and Technology, as well as domestic cyclicals like Consumer Discretionary, all look poised to underperform in weeks to come. Conversely, our work is calling for relative strength from Utilities, Consumer Staples and Telecom (Energy appears to be an exception, as this economically sensitive segment of the market is expected to continue to lead into early July).
Our read of the performance of stocks versus bonds also appears consistent with a message of resurgent leadership from defensives. Our next chart demonstrates the price path of the iShares Core U.S. Aggregate Bond ETF ($AGG), a proxy for investment-grade, domestic fixed income, and the relative performance of $AGG versus the SPDR S&P 500 ETF ($SPY), a surrogate for domestic equity.
First, observe in the chart that a trend of outperformance by fixed income has been in effect since last summer (defined by the sequence of higher highs and higher lows in the $AGG vs $SPY series). Further, we observe that while stocks bested bonds by 1,436 bps (excluding dividends and coupons) between Feb 11th and April 20th, the recent disparity in returns has merely driven relative performance back to trendline support. Bonds beating stocks from here would be perfectly consistent with the July and November 2015 tests of this trendline, both of which presaged powerful relative runs from bonds. This outcome therefore seems fitting.
Fixed Income outperformance also appears a reasonable expectation given that longer-term momentum for bonds versus stocks still favors the former. Monthly momentum (pictured in the bottom pane of the chart below) first highlighted a bond over stocks bias in December 2013, after a year in which $ACWI outpaced $AGG by 2,403 bps (excluding dividends and interest payments). Over the 28+ months that call has been active, domestic, investment-grade fixed income has fared 478 bps better than its higher volatility/higher growth, global counterpart (again, performance comparisons are gross of any income distributions).
Moreover, weekly momentum for our bonds versus stocks proxy (pictured in the middle pane of Exhibit 4) bottomed last week and looks poised to improve into early-August. Taken together, medium and longer-term relative momentum readings imply that equity markets are likely on the cusp of a medium-term correction, however, this bout of weakness for stocks will probably represent a ‘back the truck up’ opportunity to overweight stocks at the expense of bonds. Thus, while defense clearly appears prudent over the medium-term, we do anticipate assuming an aggressive equity overweight later this summer.
Our final argument for defensives over cyclicals across the medium-term is rooted in recent absolute equity price action. Per Exhibit 5, $ACWI’s 14% run off its February low has left global equities medium-term overbought, and a correction is needed to remedy this condition. As defensives tend to shine brightest in environments of broad market weakness, this observation too is inline with our expectation for sector rotation back to defensives.
Bottom line: We are looking for the defensives complex (namely Utilities, Staples and Telecom) to resume equity market leadership in days just ahead. It appears probable that such a control shift will unfold along with with a broader market correction. If we are right, January 2016 might offer a positioning playbook for what lies just ahead.
Interestingly, the best performing sectors during the January sell-off were Utilities, Telecom, Consumer Staples and Energy–precisely the areas momentum expects to lead going forward.
Importantly though, while we are inclined to reposition assets under our care in accordance with our cautious 2-3 month outlook, we warn investors against getting too bearish at present. Evidence continues to mount in favor of a cyclical economic recovery, and a macro rebound in activity should support equity share prices. Gerard Minack (former global equity strategist at Morgan Stanley) found in a 2011 note (“Downunder Daily: Cycle Drives Post-Bubble”) that equity markets tend to become tethered to the macro cycle in the wake of bubble. Minack highlighted the plight of Japanese equities since 1990 and the U.S. stock market (as proxied by the Dow Jones Industrial Average) between 1966 and 1982 as examples of the strong linkage between the the cycle and equity price action.
Support for the notion of an economic recovery takes the form of 1) leading economic indicators that suggest slow, but no longer slowing growth, 2) the dramatic tightening of credit spreads coincident with the stock market advance of the last few months–spreads have been empirically demonstrated to predict real economic activity both domestically and abroad, 3) our longer-term sector momentum indications that favor late-cycle industries to lead into next year and 4) our expectation that relative momentum for that higher-beta and export-dependent geographies such as emerging markets and Asia ex-Japan will bottom this summer and lead markets higher over the next several quarters.