Summing Up Q2: Stock Returns by Sector and Market Cap

What a quarter it was! As I predicted near the beginning of the year, Q2 was the first positive one for equities since the summer of 2007. I was obviously a bit surprised with the extent of the rally, as I had been looking for the S&P 500 to find a peak in the range of 860-920. I expect that stocks will decline this quarter as we backfill.

My outlook hasn't really changed from the beginning of the year - still looking for "the" bottom in Q4, though it may very well be that the March lows ultimately hold. I am not ready to share my outlook for 2010 (as it depends a lot on what happens in the next few months), but I expect a dull market at best as the economy remains pressured. If we don't back up now, I predict it will most likely be a tough 2010.

In the chart below, I have arranged the returns of each of the economic sectors by market cap (Large-Cap, Mid-Cap, Small-Cap). I have color-coded it so that green represents a 5% excess for the quarter relative to the underlying index and 7% for YTD. Similarly, red represents a 5% short-fall relative to the index for the quarter and 7% for YTD:

Click to enlarge

Source: Standard & Poors

The first thing that jumps out at me is the stark difference in the returns across market capitalizations for Energy, with S&P 500 declining 10% while S&P 600 increased 40%. Anyone familiar with my contributions might recall my article from March 28th pointing out this opportunity. I think that the trade has probably gone too far the other way at this point and am cautious on smaller Energy names.

The second thing that begs attention is that Technology extended its relative gains across capitalizations. This performance is quite impressive given that the market conditions were essentially mirrors in the two quarters. Technology is at or near the top in all capitalizations, especially so in Large-Cap. The final general observation I care to share is that Large-Cap Staples and Health performed starkly differently than in Mid-Cap and Small-Cap. I tend to think that this is a function of "big money" increasing its risk profile, essentially "buying beta".

During the quarter, generally smaller names tended to do better than larger names. I have already mentioned Energy's behavior. Interestingly, while it has lagged YTD for the S&P 500, it is one of the strongest sectors for other capitalizations. I mentioned earlier this year that I favored the sector for its better-than-average balance sheets.

In Materials, Small-Cap surged but remains a laggard on the year. I believe that this action reflects how cheap it got in Q1. Industrials are the weakest area in the S&P 500 YTD despite some "catch-up" this quarter. I continue to believe that this sector will underperform due to the stretched balance sheets of the larger companies with captive finance arms.

Consumer Discretionary was uniformly slightly stronger than the overall market. In smaller capitalizations, it remains one of the leaders on the year thus far. Staples are somewhat of a conundrum, with Large-Cap and Mid-Cap suffering during the quarter relative to the Small-Caps, which were able to keep pace with the index. One advantage that the smaller names have is better growth profiles. Also, they tend to have better relative balance sheets. YTD, this has been a hot sector outside of the S&P 500.

Healthcare was in line outside the S&P 500, which was weighed down by a weak biotech tape. I personally hope to see the S&P 600 return for this sector elevate relative to the market, as I have about 1/3 of my equity exposure in those types of names.

Financials were extremely strong for the S&P 500 but quite below average for the smaller capitalizations, reversing out the relative performance over the past year or so. The sector continues to lag the overall market across all capitalizations (anyone else see the yellow flag waving?). Additionally, it is pretty clear that smaller institutions are now struggling with deteriorating credit.

Tech - yowsa. They win in a bear market, they win in a bull! I mentioned early in the year that the sector has one of the strongest balance sheets generally, which helped in Q1. Beta-grabbing helped in Q2. My editorial comment is that this is a mean-reversion waiting to happen (I own none personally or in either of my model portfolios). The final two sectors, which are pretty small, suffered for different reasons. Telecom Services is reflecting a competitive pricing environment and very leveraged balance sheets, while Utilities got hurt by the beta trade as well as the rise in long-term interest rates.

Disclosure: No stocks mentioned

Comments

[donzelion:]

I concur with your preference for health-care long-term, but for different reasons. Health care is moving from "blockbuster fixation" to 'global margins' model: consolidation permits adding a few pennies per dose in emerging markets (where future growth will dominate) even if "blockbusters" don't materialize (emerging markets never paid full price per dose on blockbusters anyway). Such benefits may be 2-5 years away.

In consumer staples, discretionary, and basic retail, I like the growth prospects for smaller foreign players rather than large established brands: JNJ and even MCD may be "staples" in the States, but they're "luxury novelties" in India, China, and the Middle East, where buyers tend to be hyper-value conscious (why buy name brand goods when a knock-off is 90% as good at 70% of the price? answer in the emerging markets: unless it's a mobile phone, don't bother...).

I share your views on overall shape of the market: massive bounce in March/April, likely backfilling for next 3 months, maybe a retest of the lows by fall, and then gradually falling into a trading range. I see steady dividend payers as the best picks during the next 2- years.

Jul 02 05:10 AM