Investors with a short-term inclination typically live by the mantra “stick with what’s working.” While that advice often proves highly effective, other times it can be destructive unless you give closer consideration to why an investment is outperforming.
A look at what sectors worked and didn’t work in the first half — and more important, why each sector performed as it did — provides some clues as to what we can expect in the six months still to come.
Two factors emerged as the leading drivers of headline-level performance in the first six months of the year: bond yields and China. The impact each of these issues had is visible in the table below:
|Sector SPDR||Ticker||Return, 12/31-6/30||Return, 12/31-4/30||Return, 4/30-6/30|
|SPDR S&P 500 ETF||SPY||13.8%||12.6%||1.0%|
|Health Care SPDR||XLV||20.4%||19.2%||1.0%|
|Consumer Discretionary SPDR||XLY||19.6%||15.5%||3.6%|
|Consumer Staples SPDR||XLP||15.0%||17.9%||-2.5%|
|iShares Telecommunications ETF||IYZ||8.2%||11.1%||-2.6%|
Rising Bond Yields a Game-Changer in the Spring
The most glaring trend that jumps out from this table is the way performance results shifted once bond yields began to rise in May. Although the general storyline in the media is that the collapse in the bond market hurt the performance of all defensive, high-dividend stocks, that’s only partially true.
In the case of consumer staples, utilities and telecommunications, rising yields indeed took a heavy toll on performance and punished those who failed to lighten up in these winning groups. But in healthcare, that wasn’t the case: The sector bucked the trend among defensives and outperformed the broader market during both the first four months and the last two months of the period.
Financials, meanwhile, didn’t just survive the environment of rising rates, but they excelled thanks to the positive impact of the steepening yield curve is expected to have on future earnings. Similarly, the consumer discretionary sector shook off concerns about rising rates and continued to power ahead.
Economic Sensitivity Was a Headwind
The second factor driving the shifts in market performance was the concern about global growth in general, and China’s growth rate in particular. Materials, energy and technology all lagged through both halves of the period, indicating that investors fleeing the defensive sectors had no inclination to rotate into market segments with cyclical exposure.
Of the sectors most sensitive to global growth, only industrials managed to move from underperformance in the January-April interval to outperformance in May and June.
Financials, Healthcare and Consumer Discretionary Sectors in a Unique Position
These results help shine a light on what might work, and what won’t, during the second half.
While the worries about rising bond yields and China’s slowdown are likely overdone in the short-term, both are likely to remain important headwinds to market performance in the next six months.
In the event that yields maintain an upward trajectory, staples, telecoms and utilities — which have all revealed themselves to be highly vulnerable to a downturn in the bond market — will face a tough road … all the more so since each group continues to be saddled with valuations that are far above their historical averages. As a result, these three sectors are highly likely to be hamstrung by ongoing speculation about “tapering” throughout the second half.
Investors should question whether the next six to 12 months is a good time to own investments that could be hit by further volatility in bonds.
The second factor that drove first-half results — China — also remains very much in play. The country’s growth continues to slow, and officials are demonstrating a willingness to let GDP take a short-term hit to keep the credit bubble from expanding any further. China’s economy remains in a precarious position as the second half begins, which means any sector with sensitivity to global growth is vulnerable once the inevitable “dead-cat bounce” runs its course. That includes the same groups that lagged in the first half: energy, materials and, to a lesser extent, industrials and technology.
This brings us to the three market segments that outperformed in both the January-April and May-June periods: financials, consumer discretionary and healthcare. What do these groups have in common?
First, they aren’t particularly sensitive to the bond market or, in the case of financials, they might actually benefit from rising rates. Second, growth is driven much more by company-specific developments and/or domestic economic conditions than it is by global factors — which means these groups are less vulnerable to reduced earnings estimates than other areas of the market.
More of the Same in the Second Half
Given the reasons for the strong showing of these sectors, all look to be in a favorable position for continued outperformance in the second half. Financials, consumer discretionary and healthcare all provide investors with the opportunity to pick individual companies that can rise and fall on their own merits rather than a reaction to the latest economic report from the United States or China.
This should prove to be a valuable trait in a period that’s likely to bring higher volatility and greater uncertainty than we witnessed through the first half of the year.
In this case, it looks like investors indeed will be well-served by sticking with the winners.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.