"Whatever precautions you take so the photograph will look like this or that, there comes a moment when the photograph surprises you. It is the other's gaze that wins out and decides." - Jacques Derrida
This is the Lead-Lag Report for May 1, 2019.
Below is an assessment of the performance of some of the most important sectors and asset classes relative to each other, with an interpretation of what underlying market dynamics may be signaling about the future direction of risk-taking by investors. The below charts are all price ratios which show the underlying trend of the numerator relative to the denominator. A rising price ratio means the numerator is outperforming (up more/down less) the denominator.
Leaders: The Rally Is Getting More Narrow
Technology (XLK) – Taking A Breather
Comments: The cyclical rally takes a bit of a break over the past week as traders make a minor rotation into more defensive areas of the market. This is far from a reversal in course at this point as strong GDP readings and encouraging signs on the trade front keep investors in risk-on mode. Tech remains the top performing sector year-to-date.
Consumer Discretionary (XLY) – The Cyclical Trades Takes A Break
Comments: This sector got Amazon-ed (NASDAQ:AMZN) a bit this week as the retail juggernaut’s push toward one-day free shipping put a dent in the other major retailers, but the macro story here remains the consumer’s willingness to spend. Retail sales and consumer spending have both rebounded strongly after holiday season weakness, suggesting that the bulls remain in control here and the cyclical rally could continue.
Financials (XLF) – Confirmation Of Investor Confidence
Comments: It’s often said that the equity markets can’t make a sustained push higher without leadership from the financial sector. That’s finally begun happening over the past month as investors show more conviction in the strength of the economy. An improvement on the long end of the yield curve has correlated directly with the rally in bank stocks providing an encouraging sign for the prospect of future corporate lending growth.
Communication Services (XLC) – Breakthrough
Comments: This sector been one of the market’s best performers over the past month as healthy active user growth pushes the social media subsector higher. Revenue growth concerns exist within other areas of the sector as Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) reported a slowdown and Netflix (NASDAQ:NFLX) deals with competition from Disney’s (NYSE:DIS) new streaming service. The economic backdrop for this group remains positive as discretionary spending still looks good.
Junk Debt (JNK) – The Rally Is Peaking
Comments: The junk bond rally that has roared ahead for almost all of 2019 shows signs of hitting a plateau relative to Treasuries. The direction of the high-yield market from here could be a good benchmark for where traders see the economy going from here. Right now, investors remain confident but any swing in sentiment to the downside in this ratio could be viewed as a turning of the tide.
Treasury Inflation Protected Securities (IPE) – Underpricing Inflation Fears?
Comments: Inflation has held steady in the 1.5-2.0% range but the relative outperformance in TIPS could be suggesting that the market is expecting higher inflation in the future. The 10-year TIPS/Treasury spread has risen from 1.7% at the beginning of the year to nearly 2% today. Part of the outperformance is due to falling rates on the long end of the curve but the rise in this spread is worth watching from here.
Laggards: Small-caps And Lumber Flashing Caution Signals
Small-Caps (SLY) – A Warning Sign For The Rest Of The Market?
Comments: In healthy broad market rallies, we typically see small caps leading the way but that’s not what we’ve been seeing lately. They outperformed during the first two months of the year but have since given way to large caps. When the market rally is being driven almost exclusively by the mega caps, it could be a signal that it’s approaching its zenith. This has not been a broad rally lately.
Industrials (XLI) – No GDP Boost
Comments: A healthy economy tends to result in increased optimism in the industrial sector but the group has been struggling to buy into this economy. Manufacturing PMI while still in expansionary territory has slowed significantly from 2018 increasing concerns about where we head from here. GE’s 2019 story should be viewed more as a corporate turnaround than a signal of strength in the industrials.
Materials (XLB) – Directionless
Comments: Materials stocks continue to drift lower in largely directionless trading. This is a bit of a mixed indicator since a strong economy should be reflected in stronger demand for the basic materials used in construction. Weakness in this group could be viewed in a similar vein as weakness in lumber. It could be telling us that the economy is flashing some warning signs that aren’t necessarily being reflected in the high level economic figures.
Real Estate (XLRE) – Weakness Despite A Strong Economy
Comments: The real estate sector is coming back down to earth as the rally that occurred during the first quarter has come to a close. The rate-sensitive group has retreated as interest rates rose, but the move does raise some questions. A strong economy should be considered bullish as occupancies tend to increase and it gives landlords the ability to raise rents. There could be some economic concerns built into this pullback.
Health Care (XLV) – Bottom Could Be In
Comments: Healthcare stocks have been huge underperformers since late last year so a buy-low bounce was probably inevitable. The question is whether this is value traders swooping in or a move into more defensive positioning. One week does not a rebound make but this ratio is worth keeping an eye on as a continued uptrend could suggest that investors are changing their tune.
Utilities (XLU) – Investors Showing No Fear
Comments: Utilities have drawn little interest for nearly two months as the preference for growth continues. This ratio should spike if investors get spooked, but so far we’re not seeing that reflected in this ratio. A rise in utilities in conjunction with Treasuries could be a signal of a more sustained rotation into defensive positioning.
Energy (XLE) – Failing To Keep Up With Oil Prices
Comments: The concern with this chart is that it signals that energy stocks are failing to take advantage of the rise in oil prices. There’s a lot going on in the political environment surrounding oil (President Trump recently called for OPEC to lower oil prices) but traders appear less convinced that oil prices are reflective of increased demand, especially considering the impact of higher prices at the pump. It’s effectively due to supply controls.
Consumer Staples (XLP) – No Interest In The Defensive Plays
Comments: Like utilities, consumer staples are drifting lower as investors focus on cyclicals. The group looks relatively healthy from a balance sheet standpoint but there looks to be little impetus here for a sustained move higher.
Emerging Markets (EEM) – Failing To Hold
Comments: I stated last week that emerging markets could be forming a base that allows the group to move higher based on a relative value and forward growth story. That base broke down in the past couple weeks as traders kept their money at home. This breakdown raises concerns that this rally is narrow and essentially focused on just one area of the market - U.S. large-cap cyclicals.
Europe, Australasia, and the Far East (EFA) – Home Bias Continues
Comments: There’s some signs of encouragement coming out of the Eurozone as GDP growth jumped by 0.4% in the first quarter. Additionally, Italy emerged from recession after two quarters of negative YoY GDP growth. That’s given a bit of a boost to Euro equities but Asian weakness has kept the overall downtrend in place.
Bonds (TLH) – No Signs Of Strength...Yet
Comments: Treasuries and equities moved up together during the first part of the year. In the past month, however, they’ve diverged again furthering the notion of relative strength in equities. Investors at this point seem to be giving more weight to the high level economic data instead of the notable disconnect between rising equity values and negative year-over-year earnings growth.
Long Bonds (TLH) – Not Buying The Growth Story
Comments: Long-term Treasuries have been priced as if they’re anticipating economic weakness instead of expansion. When unemployment, GDP growth and inflation have historically been at the levels they are now, the Fed Funds rate has typically been at least 100 basis points higher. Long-term Treasury yields, however, have been reticent to budge off of their current levels and the Fed seems disinclined to help them move higher from here.
Lumber (LUMBER) – Trouble Ahead?
Comments: Lumber tends to be a leading indicator of economic expansion. Higher demand for lumber and building materials is indicative of growth and demand for housing and other developments that tend to occur in stronger economies. The price of lumber relative to gold hasn’t just fallen in the past year, it’s fallen significantly. Weakness in lumber prices is perhaps the biggest red flag we’re seeing in the economy right now and should be considered a warning to equity investors, and a potential precursor to a Spring Crash as I spoke about recently on Real Vision (here).
Conclusion? While the most popular economic indicators tell us that the economy is doing great, some of the data below the surface suggests it’s more of a mixed bag. Weakness in energy stocks, the materials sector and, most importantly, lumber suggest that investors should at least be considering a defensive shift at this point. The current stock market rally is very narrow existing mostly in just large-cap cyclicals. Relative weakness in small caps indicates the current rally could be getting long in the tooth.
This writing is for informational purposes only. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. It also does not offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.