Eye on the Markets - 2017

Not So Quiet Summer Markets

By Ketu Desai

The month of June appeared to be quiet on the surface, but lurking underneath the seeming calm things were quite interesting. In this article, we will review recent market activity including the recent sector rotation, and discuss latest economic and corporate data.

Across many markets, much of what to June, underperformed during the month. Within the equity markets, the Russell (small capitalizations stocks), which has lagged the S&P for much of the year, began its effort to catch-up. Even within specific sectors and factors this was the case. More on this below. The one notable exception has been energy. While oil rallied during the last week of the month, WTI traded into the low-$40s. As mentioned many times here, the supply and demand dynamics continue to remain unfavorable for prices. Prices for energy stocks have reflected this. Energy stocks have underperformed the S&P by approximately 20 percent this year and top performing sectors such as tech and healthcare by 25 percent.

In other asset classes, gold gave back gains, as did Treasuries. The 10-year treasuries rallied much of the month, and then yields spiked 15 basis points during the last week of the month. The primary driver appears to be a more hawkish tone from the Fed, and even potentially the European Central Bank. In other words, central banks appear to be more aggressive in raising interest rates and reducing stimulus provided during the financial crisis. It remains to be seen what will be the turning point for interest rates.

While the S&P ended the month with only a small gain, there was some turmoil among various sectors. A few large capitalization technology stocks, Apple, Google, Facebook, Amazon, Microsoft have generated roughly 40 percent of the S&P 500's gains this year. On a Friday afternoon in early June, on limited news, and certainly no fundamental news, these stocks started a reversal. Many explanations have been offered as to why these stocks started to fall then, including a Goldman Sachs' research note. Tech stocks fell approximately 3 percent on that day, and the negative sentiment remained for the remainder of the month. It appears that the selling was a combination of sector rotation and profit-taking, as we approached a quarter-end. Sector rotation is, simply, investors moving capital from one sector into another.

While in the larger picture, the move is not very significant, the move does highlight the broad ownership of technology stocks across various investment styles and factors. It is not frequent where you see the same names in growth, value, equity income, momentum, and low-volatility portfolios, and that is what you were seeing with many of these names. The move also emphasizes the importance of understanding the underlying portfolio exposures and true factor diversification. For instance, a portfolio with Vanguard Growth ETF, iShares Value ETF, and Vanguard High Dividend Yield ETF - three seemingly different factors, would have over 20 percent in exposure to technology. The risk is when there is a sell-off in technology, a portfolio that you think is diversified, may suffer more losses than anticipated.

As the money flowed out of technology, generally, growth dollars flew to biotech, and value dollars flew to financials. Biotech and financials also benefited from news out of Washington.

The market perceived the Senate healthcare bill as positive for biotech, as well as results from the Federal Reserve stress tests on banks.

This sector rotation has generally favored value, as for the year, Russell 1000 growth has outperformed value by nearly 10 percent. Value stocks are ones that trade below their fundamental value, it could be cheap on an earnings basis, cash-flow, dividend, etc.

Growth stocks are ones that are expected to provide high level of sales or earnings growth in the future. During the year, growth has outperformed, as the economy appears to be stuck in a 2 percent growth environment, investors are willing to pay for higher levels of growth, the majority of which is coming from the technology sector.

First quarter GDP got revised up again to 1.4 percent from a revised 1.2 percent and an initial 0.7 percent. First-quarter economic growth was boosted by an upward revision to consumer spending, which accounts for more than two-thirds of U.S. economic activity.

While Q1 looks better, the reading from the Atlanta Fed on Q2 continues to move down, and now stands at 2.7 percent. While noisy, the direction of this series has been down, it was north of 4 percent earlier in the quarter. Such growth numbers suggest that high growth is valuable, and that the sell-off in technology stocks is simply a rotation, and not a commentary on their business fundamentals.

Looking forward, we will start to receive earnings reports in the coming weeks. Q2 earnings are expected to grow 6.6 percent with 4.9 percent revenue growth. It will be an exciting summer in the markets!