You know interest rates have been really low for a long time when the dividend darlings of the utilities sector sell off supposedly because the yield on the 10-year note spiked to 2.15%. Oh, the horror! It is also the easy explanation for why the S&P Utilities sector and a few of its generous dividend-paying cohorts languished during an otherwise very good month for the broader market.
The underperformance, however, is owed to more than just rising interest rates. Investors aren't really leaving utility stocks behind because they think a 2.15% yield on the 10-year Treasury note is way more competitive now. That's a joke. They sold utility stocks because:
- The sector was overbought, having risen 22% between mid-November and the end of April versus an 18% gain for the S&P 500
- Valuation was stretched with the S&P Utilities sector trading at 16.5x forward 12-month earnings versus a 10-year average of 13.8x, according to FactSet estimates; and
- Market participants got back into a groove of buying into the belief that growth is going to accelerate in the months ahead.
That last point is perhaps the best explanation for the underperformance of the utilities sector. It certainly holds up against questioning when taking into account that most cyclical sectors outperformed handily in May while the counter cyclical sectors all trailed the broader market.
The utilities sector has been the worst-performing sector in May, yet the telecom services sector - another area known for healthy dividend yields - has gotten disconnected too, declining 6.1%. As it so happens, the telecom services sector was the only other sector more overvalued relative to its long-term average entering May [18x vs. 15x] than the utilities sector.
Simply put, what transpired in May was the epitome of sector rotation and the manifestation of a newfound attitude about the growth outlook.
The Tables Have Turned
In our April 8 piece, A Phantom Menace, we highlighted some developments that supported the notion that there were concerns in the market about the growth outlook. That piece came in the wake of the disappointing March employment report and it called attention to the weakness in base metal prices, the outperformance of the counter cyclical sectors in the first quarter, and the notable drop in the 10-year Treasury yield.
Not quite two months later, the tables have turned somewhat. We can't say that base metal prices have picked up much since early April, but the cyclical sectors have taken over the leadership role and Treasury yields have backed up.
The April employment report, which was much better than feared, had a lot to do with turning the tide.
Another rush of monetary policy support from the world's leading central banks also played a big part.
- The ECB cut its key lending rate to a record low 0.50%
- The Federal Reserve noted it could increase its asset purchases if the data warranted such a move; and
- The Bank of Japan announced a quantitative easing program that made the Fed look downright tight in comparison.
There has been a lot of debate of course over the Fed's future policy path. The prevailing thought at the moment is that the Fed is likely to taper its asset purchases in the next few meetings.
The market has been rather fitful over that last thought. We can understand why. After four plus years of unbridled policy support, it takes some getting used to the idea that the Fed might soon become a little less easy with its monetary policy.
The Fed would presumably do so for the right reasons (i.e., growth is picking up to facilitate a sustained improvement in the labor market), but, as we noted last week, the Fed seems a bit unclear on what data it should be looking at to make the monumental decision to taper its asset purchases.
That internal debate has created some external uncertainty, and volatility, in the marketplace about the Fed getting its timing right.
Roots in Relative Value
We have some reservations about the stock market's capacity to handle the tapering truth with a sense of aplomb, but the fact of the market matter is that the cyclical sectors exhibited the best relative strength in May when talk of tapering was increasing, when interest rates were rising, and when growth indicators in China and the eurozone were generally disappointing.
Another key consideration is that the cyclical sectors led the U.S. stock market to new record highs.
The attraction to those sectors was rooted in relative value, but it seemingly flourished on the belief that economic activity will be accelerating in the second half of the year. To be sure, cyclical stocks don't go up en masse if conventional wisdom holds that the economy will be slowing down.
That mentality though could shift on an employment report, a geopolitical incident, or some other pernicious development, like a spike in interest rates for example, that is seen as a retardant for growth. Any and/or all of those things could drive the countercyclical sectors back into a leadership position or a position at least of relative strength.
What It All Means
What has been clear for some time is that money is moving within the stock market and not necessarily out of it regardless of the prevailing headlines. There has been a sector rotation, but not a stock market dislocation because there is a strong current of thought among professional money managers that there is simply no better alternative for yield right now than the stock market.
Note there hasn't been a 5% pullback in the S&P 500 in more than six months.
That last fact leaves all stocks at risk, yet we would argue that cyclical stocks face a heightened risk in the event there is a material sell-off since it will likely be precipitated by a real scare over the growth outlook and/or policy error.
A concluding thought is to respect the stock market action but don't take it for granted. Notwithstanding the market's position near record highs, it can be said that this is still a fickle market where sector allegiances are apt to shift with the prevailing wind of economic sentiment.
The counter cyclical sectors got overvalued in the market's quest for higher yields and amid concerns about the growth outlook. They are now suffering the effects of a crowded trade becoming less crowded.
The recent jump in interest rates has offered a good excuse to take profits. The real overhang for the counter cyclical sectors, however, is that the market's feelings about the growth outlook have changed for the better. Consequently, the previous quest for yield has been supplanted by the quest for capital appreciation.
Investors, though, need diversification in their equity portfolios. That includes owning both cyclical and counter cyclical stocks.
The latter have fallen out of favor for now, yet the income stream they provide hasn't stopped flowing. Importantly for income-oriented investors, those dividend payments are unlikely to disappear if the market's newfound faith in the growth outlook and quest for capital appreciation do.