What’s up with this market?
Despite solid first quarter earnings, consistently strong jobs numbers and the continuation of a nine year bull market, investors are beginning to wonder why the market (and their portfolio) isn’t reacting to the improving state of the economy. While this is all true, the reasoning may not be the market; instead, it could be that your portfolio is stuck in 2017.
Historically, the market looks six months out, and as the last six months were strong, investors were pricing that in. Now the pendulum is expected to swing the other way. The economy is in the process of transitioning into a late phase of recovery, and in order to benefit, it’s important to position your portfolio in areas that will become stronger as the growth wanes. To prepare for a potential increase in economic volatility ahead, investors should consider the benefits of the sector rotation model, which was designed to participate in the market swings when they are providing the most opportunity.
The sector rotation model may sound complicated, but if you understand the potential benefits, it’s worthwhile to consider. Just like the markets, the economy moves up and down and stocks tend to chase earnings. In order to understand the thinking behind the sector rotation model, we need to take a look at the stages of the market and how different sectors respond accordingly.
When the market is in the early-to-mid stages of recovering and consumer expectations are rising, cyclical sectors such as industrials and energy historically perform well, beating out defensive sectors such as consumer staples and healthcare go on the decline or flat, respectively. At this phase, investors should consider being aggressive in their portfolios and avoid these sectors.
When the economy starts to slow and interest rates are increasing, consumer staples and healthcare sectors are back in style. In this market environment, investors should have some exposure to these defensive sectors, as they present more opportunity for growth and provide a defense against potential volatility.
Where to Take Caution
One sector that may not perform well regardless of where the rotation stands is technology. Investors should take caution here, especially if the economy starts to slow down or taper off, which will could cause global technology sales to flatten. In times of sensitivity, the technology sector is a lot more connected to the U.S. dollar than many tend to realize. This is because a lot of sales in technology are derived from global markets, and if more money begins flowing into the U.S., the dollar will likely start to strengthen.
For example, Apple (AAPL) gets more than 60% of its sales overseas. It therefore could be hurt.
Where We Stand Today
The thinking behind the sector allocation model is that in a period of slowing economic activity, you are likely paying a premium for companies that are performing well and have stable cash flow. So where do we stand in today’s market? Key indicators are showing that we are entering a cresting economy include a flattening yield curve, rising interest rates, flattening industrial production and waning consumer expectations. Currently, two of those factors — the flattening yield curve and rising rates — are in play. Market expectations are still strong, but sectors that have been laggards will begin to outperform in a slowing environment.
There is opportunity for investors during this time of decelerating economic activity, and portfolios will benefit from investing in stocks that have consistent, less volatile earnings potential.
Stocks go in and out of style, as do sectors. As an investor, it is important to take a long-term look at the market and hedge your bets, while also keeping in tune with unexpected economic factors that come into play. You don’t want to be sitting with yesterday’s portfolio as we head into the back half of the year. Investors also need to keep in mind that past performance in the stock market does not always mean future success and a particular sector may or may not be favorable at any time.
By: David Malmgren, CFA, Senior Portfolio Manager
David has served as a Portfolio Manager to FBB clients for over a decade. David actively works with clients to identify investment strategies, evaluate current financial goals and manage their investment portfolios. As a member of the investment committee, David also provides research and guidance to the team related to current and future investment opportunities and manages the firm’s growth momentum strategy.