Has the stock market reached a turning point? While such moments are incredibly difficult to call—most investors would do well to avoid trying to time the market—a few signals have appeared suggesting a shake-up among the leaders and laggards may be afoot.
To be clear, this doesn’t necessarily mean the stock market is on the verge of another correction. The S&P 500® Index is back near record highs, and it’s entirely possible the market will return to the groove that has powered it higher this year. But for the moment, things are in flux.
“More defensive sectors have started to perform better, with both the health care and utilities sectors outperforming over the past three months,” says Brad Sorensen, managing director of market and sector analysis for the Schwab Center for Financial Research. “At the same time, the information technology sector—which has been the S&P 500 Index’s star performer this year—has started to move more in line with the overall market.”
As a result, Brad has adjusted some of his sector ratings to account for the new conditions: He no longer sees the technology and financial sectors as potential outperformers, and has now adopted a more neutral stance. At the same time, he has upgraded utilities and real estate, lifting them out of the laggard zone. Here’s why.
Conditions are changing
Two big currents are flowing through the markets right now that can help explain some of the changes taking place.
The first is the Federal Reserve’s monetary tightening campaign. It has raised rates seven times since its tightening cycle began in December 2015. Two of those hikes came earlier this year, and the Fed sees two more hikes before the year is out. Meanwhile, the Fed is also scaling back the massive pile of bonds it acquired in the wake of the financial crisis. These tightening programs effectively siphon some of the money supply out of the economy. Shifting monetary conditions can create turbulence in different parts of the economy.
The second current comes from the tensions surrounding global trade. More than half of the sales of the companies that make up the world’s stock market (as represented by the MSCI World Index) now come from outside their home country, according to Factset data. Even domestic sales can be affected when our increasingly interconnected global supply chains are tweaked. Companies may be more sensitive to bottlenecks or border issues than in the past.
The trade tensions may be making people nervous. The Institute for Supply Management’s latest manufacturing survey noted that 49% of respondents expressed concern about the trade situation. The survey also showed that overall manufacturing activity dipped in July, particularly its forward-looking new orders index. That could be a source of concern, as it implies business leaders may be less sanguine than they were earlier this year.
This is all playing out against a backdrop of accelerating economic growth that could be hard to sustain as the effects of the recent tax cuts and easing of regulations fade. Inflation is also starting to pick up.
Impact on sectors
These changes help explain why some of the shine has come off the tech and financial sectors. Again, Brad still expects these sectors to perform in line with the rest of the market, but their days of outperformance may be on hold for now.
“Our concern is that corporate uncertainty could delay some planned capital expenditures, which could negatively affect both tech spending and loan demand,” says Brad. “That could also dent merger and acquisition activity as companies wait for a resolution to the trade uncertainty.”
These sectors’ recent outperformance could also start to work against them.
“The almost-completed earnings reporting season saw tech companies beat earnings estimates at a rate of 89%, according to Thomson Reuters—a tough number to repeat in coming quarters, in our view, especially when analysts are raising estimates for upcoming quarters,” says Brad. “And don’t forget that in September, some big names—Facebook and Alphabet among them—are going to be leaving the technology sector for the new communications sector. This will result in the technology sector shrinking from about 26% of the market to about 22%—that’s not necessarily a negative, but it could mean a period of adjustment for the sector.”
“With financials, we think most of the tailwind from regulatory easing is complete, at least for the near term, while we’ve seen mortgage applications fall recently, according to the Mortgage Banking Association, which could affect bank profitability.”
“Our fixed income strategists have noted another potential problem for the financial sector: The yield curve is likely to continue flattening, which could hurt the profitability of banks and others within the sector,” Brad says.
Brad also no longer expects real estate and utilities to underperform the broader market. With longer-term interest rates unlikely to move much higher, these higher-yielding sectors might start to look more appealing to investors. At the same time, these two sectors may be slightly undervalued in terms of price-to-earnings growth. These factors could help these sectors out of the doldrums.
All things considered, shifting conditions aren’t a reason to totally remake your portfolio. We believe it’s important to have some exposure to each of the 11 sectors in the S&P 500 Index, and to keep it within a reasonable range—say, a few percentage points—of the market weighting. Sector returns can vary greatly from year to year—for example, tech could lead the pack one year and then lag behind another—so it could be risky to be excessively over- or underexposed to any particular sector.