If the financial markets truly discount the outlook six months down the road, the prospects for the global economy are bright indeed.
The past month has brought a strong recovery in the market segments most directly tied to the growth outlook, indicating that investors are feeling better following the growth scare of early April. Among the signs of the pro-cyclical shift are:
Click to Enlarge The Materials SPDR (NYSE:XLB) and Industrials SPDR (NYSE:XLI) have both moved out to 52-week highs. XLI is at an all-time high, while XLB is at its highest level since August 2011. The Technology SPDR (NYSE:XLK) also has rallied 6.9% since April 18, outpacing the 5.5% move of the S&P 500 in that interval. The revival in these cyclical sectors has been accompanied by corresponding underperformance for the defensive segments of the market, including utilities, consumer staples and healthcare. This reversal is visible in the accompanying chart.
- The emerging markets have staged a modest recovery, too. After falling steadily through the first quarter and bottoming out in mid-April, the iShares MSCI Emerging Markets Index Fund (NYSE:EEM) has surged 6.9% off of its low. Notably, the growth-sensitive BRICs (Brazil, Russia, India, China) have outperformed the broader emerging-market universe during this time.
- The bond market also is performing in a manner consistent with improving growth. The 10-year Treasury yield has finally caught up to the move in other cyclical areas, rising from 1.63% on Thursday to 1.78% on Tuesday in the wake of last week’s better-than-expected jobs report. In addition, the credit-sensitive high-yield and emerging-market sectors have staged robust rallies in the past few weeks.
Is This Move for Real?
In looking at these performance results, the most important question is whether growth is indeed set to improve, or if this is just another in the long line of head-fakes.
If the world economy finally emerged from its doldrums, deep cyclicals such as steel, coal and mining stocks would be in line for substantial gains. So far, however, the evidence of a recovery just isn’t there.
Yesterday, CNBC published a Reuters story that reported, “Global economic activity eased to its weakest pace in six months during April as expansion slowed in China, the euro zone, Japan, India and Russia” based on the Purchasing Manager Index (PMI) reports from those countries. Reuters reported that the softness in growth was broad-based, with Germany experiencing a contraction in business activity, China suffering its weakest growth prospects since August 2011, and the U.S. PMI hitting its lowest level in nine months.
This sort of a data argues for a cautious approach — and tight stops — when it comes to trading the change in market leadership that has been so widely reported in the past week. In reality, the bulk of the move might be the result of investors’ shift into risk-on mode more so than a sustainable shift.
One indication of this move is the comparative performance of PowerShares S&P 500 High Beta Portfolio (NYSE:SPHB) vs. the PowerShares S&P 500 Low Volatility Portfolio (NYSE:SPLV). Since April 18, SPHB has gained 11.3% and thoroughly trounced the 2.6% return of the popular SPLV. This is indicative of a market in which hedge funds and other short-term investors are chasing beta to play catch-up.
Gauging the Rotation’s Sustainability
Eventually, the long-awaited “great rotation” from defensive stocks to cyclicals will indeed occur. Stocks like Colgate-Palmolive (NYSE:CL), which sports a forward P/E of 19.1, are going to begin to look expensive relative to cyclicals such as Freeport-McMoRan (NYSE:FCX), at 7.4 times. For this to happen, however, investors will need to see enough evidence that the earnings of deep cyclical stocks have troughed. Otherwise, the market will continue to pay a premium for the stable earnings and high dividends of the “bond proxy” names.
Ultimately, Treasuries will be the best indicator as to whether the shift in leadership is sustainable. A continuation of the rising yields of the past few days would support the shift to cyclicals, while a reversal likely would take the steam out of the rally.
There are two reasons for this: First, rising long-term Treasury yields are a prime gauge of reduced deflation fears and a stronger growth outlook. Second, higher yields make dividend stocks less attractive on a relative basis by reducing their “spread” over government bonds. Look to Treasuries as an early indicator of relative performance for cyclicals vs. defensives.
The Bottom Line
The current market rotation has received a great deal of attention, even though it’s less than a month old. Nevertheless, the clock is ticking on this move unless there is actual evidence that growth is on track for sustained improvement — a trend that should be reflected in the bond market.
Until this occurs, exercise the utmost caution with the cyclicals.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.