The major equity averages closed out the month of April with respectable gains ranging from 1.1%-1.4%, with the exception of the Nasdaq Composite, which rallied 2.9%. Year-to-date, the major indexes are up 6.0%-6.5%, which translates into an annualized gain of 19%. If sustained, that would be the strongest performance since 2013.
Yet, the stock market’s performance is showing clear signs of slowing in recent months. The bulk of this year’s gains came in January and especially February, with the Dow Jones U.S. Total Market Index advancing 1.9% and 3.6%, respectively. Since then, stocks were flat in March, before posting modest gains in April.
The S&P 500 has traded within a fairly narrow 80 point (3.4%) range for the past two-and-a-half months. You can find significant volatility within sectors – some individual sectors have also seen strong double-digit advances and declines – but the broader market averages and standard deviations among individual sectors have been less volatile in recent months. The chart below shows that standard deviation in performance among individual sectors has declined in recent months to 30-month lows.
It is not surprising that the market would pause after realizing strong gains during the Trump rally from Nov. 7 to Mar. 1. Valuations are high. Economic growth remains lackluster, despite a surge in consumer confidence. Key parts of the President’s agenda, including healthcare and tax reform, which had boosted investor optimism immediately after the election, have hit roadblocks in Congress and in the courts. All of this has dampened somewhat the outlook for earnings growth. The stock market cannot sustain such a strong advance indefinitely without a supporting change in the fundamental outlook.
Within the stock market sectors, there are signs of churning, with no clear evidence of direction. At times, when major averages looked shaky, the so-called “risk-off” sectors (including utilities, telecommunications, health care and consumer staples) outperformed. More recently, performance has been mixed within the sectors, with no clear overarching themes evident. Performance seems to be driven more by individual industry and company dynamics.
Among the market leaders in April were technology, consumer discretionary, industrials, health care and materials. Laggards included telecommunications, energy and financials. Consumer staples, utilities and real estate were little changed during the month.
Fixed income markets have likewise echoed this theme of stalled reforms and economic growth. U.S. Treasury rates rose steadily from the start of the year until mid-March, when the FOMC raised the target range for the Fed Funds rate by a quarter point to 0.75%-1.00%, but intermediate and long-term yields have since declined and are now unchanged for the year. Short-term rates are higher as a result of the FOMC’s Fed Funds rate increases and have mostly held steady since the mid-March FOMC action.
Declining intermediate and long-term Treasury yields sparked solid gains in most fixed income sectors in April. During the course of the month, Treasury yields from 5-year to 30-year maturities declined about 10 basis points on average. This produced overall gains in Treasurys of 0.8% for the month, with long-maturities (>10 years) gaining nearly 1.5%. Investment grade corporate bonds showed average gains of 1.1% in April, with longer maturity issues gaining around 1.5%. High yield corporate bonds also gained 1.1%, but higher quality BB-rated bonds earned 1.9%, while lower-rated CCC-rated bonds earned only 0.5%. Muni bonds delivered a total return of 0.6% in April, but intermediate-term munis posted the biggest gains up nearly 1%, while both shorter and longer maturity munis earned only half of that. Overall, fixed income delivered returns commensurate with equities, but investors appeared to approach some segments of the fixed income market cautiously.
Going forward, I have my eye on several key indicators:
1. Energy stocks. The energy sector has underperformed the broader market significantly so far this year. By and large, smaller cap oil & gas companies have performed much worse than the mega cap integrated companies. Oil appears to be struggling to hold on to the $50 level. Natural gas prices have firmed since their end-of-February lows, but have softened slightly over the past few days. Last year’s rebound in the price of oil to $50-$55 has sparked a near doubling of drilling activity off of the lows, according to the Baker-Hughes rig count. Rystad Energy, a consulting firm, has recently said that the resurgence in U.S. drilling activity is likely to boost production by 100,000 barrels per day each month for the rest of the year, which in turn could put the OPEC production cuts in jeopardy. Low oil prices nearly cracked the equity markets in February 2016. A drop in oil prices below significantly below $50 could spark a market sell-off in 2017 (and possibly derail the IPO of Saudi Aramco, the world’s largest oil & gas company).
2. Financial stocks. With the drop in interest rates, financial stocks have also underperformed in April, falling about 1% on average. Banks stock and insurance stocks were down 0.75%-1.50% on average. A continuation of the rally almost certainly requires participation (if not leadership) from the financials.
3. Semiconductors. Technology stocks led the market higher in April, with strong performance from internet, software and hardware companies; but semiconductors lagged considerably. The Philadelphia Stock Exchange’s Semiconductor Index (SOXX) fell 0.3% during the month. Semis are considered a leading indicator of the Technology sector. If the underperformance continues, I would expect to see some of that weakness spill over to the other technology sectors.
4. Other Sectors. Several other indexes, sectors, such as the Dow Jones Transports, large cap Pharma and large cap Telecom (i.e. VZ and T), also underperformed during the month. Weakness in the transports could be an early indicator of a softening of economic activity. However, the weak relative performance of large cap Pharma and large cap Telecom reflect specific industry factors, such as fears of Federal pressure to lower drug prices and the impact of price competition from wireless carriers like Sprint and T-Mobile. Nevertheless, further weakness in all of these sectors would raise further concerns about the broader market outlook.
On the other hand, there were also some positive surprises during the month, including the strong performance of retail stocks and of most REITs (except surprisingly for Retail REITs). The turnaround in retail could conceivably signal an increase in consumer spending, despite the recent lackluster retail sales and GDP data. The rebound in REITs was clearly interest-rate driven
5. Technical Factors: Last week’s rally could conceivably dispel some fears about an imminent decline in the market. Take away last week’s action from the chart and the S&P 500 clearly looks like it was beginning to roll over. For now, the market remains range-bound. Still, last week’s intraday high of 2398.16 on the S&P 500 fell short of the March 1 high of 2400.98. By definition, for the rally to continue, the S&P 500 needs to put in a new high before too long. If it fails to do so, technicians may begin talking about a “double-top.” Many will not, however, begin talking about the start of a correction until the S&P 500 drops below its March 27 intraday low of 2322.25.
On balance, I believe that the market is showing some signs of weakness that could lead to a pullback in the near future. If it does pull back, I believe that this will most likely be the start of a correction (and not the beginning of a bear market).
I do not view the recent flattening of the yield curve as worrisome at this time. In my view, the financial markets are getting the best of both worlds: Rising short-term interest rates address concerns that Fed policy is dangerously accommodative and that the economy cannot handle higher short-term rates. Continued low long-term rates helps keep the party going, providing ongoing support to the economy and financial markets (but still at a cost of asset bubbles and capital market dislocations). I would become more concerned if the yield curve became inverted, which appears to be a long way off, given the current pace of Fed Funds rate increases.
For now, the long-term trend in stocks remains up. Bulls have the benefit of the doubt; bears have the burden of proof. Until there is clear evidence of a significant sell-off combined with a major adverse change in the global and U.S. economic outlook, the market is likely to continue to drift higher over time, with periodic pauses and pullbacks.
April 30, 2017
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
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