Admittedly, we've been impressed by the strength of some of the recent U.S. economic data. For example, industrial production, capacity utilization, housing starts, the NAHB/Wells Fargo Housing Market Index, the Empire State Manufacturing Survey and the Thomson Reuters/University of Michigan Consumer Sentiment Index all came in better than expected. Nonetheless, U.S. equities are still going down even on this good economic news. Why? The Minutes of the FOMC told us: "Several members indicated that additional monetary policy accommodation could be necessary if the economic recovery lost momentum or the downside risks to the forecast became great enough." One thought is that the improvement in the aforementioned macro data has reduced the probability of another round of quantitative easing, thereby dashing investors' hope for a liquidity-induced bounce in stocks.
A different and conflicting thought pertains to the broader contour of the U.S. economic landscape. Despite the improvement in IP, CapU, starts, the HMI, Empire and consumer sentiment, the Citigroup Economic Surprise Index for the U.S. is in negative territory at -19.4, meaning we're still seeing more negative surprises than positive ones. There are many different versions of these economic surprise indices; regardless of the provider, there's a systematic tendency for data surprises to cumulate over time, in our experience. More importantly, once surprises hit an extreme, they usually turn and don't stop until they hit another extreme. Indeed, the CESI troughed at -117.2 on June 3, 2011 and peaked at 91.9 on January 6, 2012. Needless to say, there's a connection between the macro backdrop and share price performance; on balance, the former hasn't been supportive of the latter.
Figure 1: The impact of shrinking liquidity, uneven macro data, a potential eurozone breakup, etc. on S&P 500 sector performance is clear
Beyond the U.S., we would be remiss if we didn't acknowledge the better-than-expected Euro Area GDP report. Germany GDP rebounded 0.5% q/q in Q1 (versus forecasts of 0.1%), helping the eurozone record flat growth for the quarter (versus forecasts of -0.2%) and avoid another recession. Nonetheless, Italy experienced a worse-than-expected contraction of -0.8% q/q, leading Moody's to downgrade 26 Italian banks by multiple notches, citing an economy back in recession, mounting asset quality challenges, and restricted access to funding markets. The ratings outlook for all of the affected banks remains negative. Elsewhere, the ECB is increasingly refusing liquidity requests from Greek banks, according to Holland's Financieele Dagblad, adding to concerns about a run on Greek banks, which have been hemorrhaging deposits. It's no mystery why top eurozone officials have been talking openly of a "Grexit", European bank stocks have broken support, and funding and sovereign spreads are widening.
How does this relate to U.S. equities? True, U.S. exports to Europe are small as a percentage of U.S. GDP, and we often hear that U.S. banks' exposure to Europe is minimal. However, contagion is a serious risk, with symptoms that can "spread" with compounding effects as we've seen. Indeed, we think of the global financial system as a circulatory system: If one part of the economic body gets infected, the sickness can be transmitted quickly to other areas.
Figure 2: S&P 500 Sector Performance (May 16, 2012)
The point we're trying to make is that shrinking liquidity (read: the change in the Fed's balance sheet), uneven economic data and a potential fragmentation of the eurozone aren't good for near-term stock market dynamics. Figure 1 illustrates the impact of these and other downside risks (e.g., slowing earnings growth, future spending cuts and tax hikes) on the various segments of the U.S. stock market. Specifically, it shows the price performance of the 10 S&P 500 GICS sectors on a year-to-date (x axis) and quarter-to-date (y axis) basis. As you can see in the southeast quadrant, many of the sectors (mostly cyclicals) that enjoyed strong rallies in the first three months of the year have done a complete about-face, and have fallen sharply since the beginning of April (-7.98% QTD as a group). Contrastingly, the defensive sectors are still generating positive returns (0.62% QTD and 3.34% YTD as a group), led by Telecommunications and Utilities (figure 2).
In figure 3, we demonstrate that overall market tone is an important determinant of sector positioning, and vice versa. Logically, when broad market action is weak, higher-beta or cyclical sectors underperform their lower-beta or counter-cyclical brethren. If our assessment of the downside risks and analysis of seasonal performance trends is any guide (please see Adding seasonal performance to our list of concerns, May 9, 2012), it could pay to maintain a cautious market stance and favor defensives over cyclicals through the spring and summer months.
Figure 3: Market strategy and sector positioning … one and the same
That said, it's possible that the market could get a momentary reprieve if the AAII bull-bear spread hits negative extremes. Interestingly, our study on seasonal performance reveals that, since 1950, the market has typically witnessed a counter-trend bounce in July and August with median monthly returns of 0.68% and 0.86%, respectively. Regardless, our study also highlights that, since 1980, defensives have usually led the rally in July and August with median monthly returns 0.38ppts and 0.59ppts greater than those of cyclicals. In figure 2, we would point out that Health Care (11.75%) and Consumer Staples (11.36%) are the third- and fourth-largest market heavyweight contenders, respectively, next to Information Technology (19.97%) and Financials (14.28%). Food for thought in troubled markets.