Rotating Sectors

Rotating Sectors
Thursday, September 15, 2016
See the pdf and the collection of the individual charts linked below.(1) S&P 500 Financials discounting Fed rate hike. (2) Dividend payers hit by profit-taking. (3) Reversal of fortune for sectors since August 15 peak in S&P 500. (4) Investors starting to focus on earnings growth forecasts for 2017. (5) Not much froth in IPO market. (6) 3D printing is a great technology, though not a great investment. (7) 3D could boost manufacturing productivity.

S&P 500 Sectors I: Losing Interest. The odds of an interest-rate hike next week have diminished substantially in the fed funds futures market, but interest-rate-sensitive stocks may be telling a different story. Since the S&P 500 peaked at a record high of 2190.15 on August 15, the S&P 500 Financials sector has been the best-performing sector, falling only 0.7% through Tuesday’s close. This relative outperformance presumably reflects expectations that higher interest rates over the next year will help Financials earn more on their loans. The sector’s low P/E relative to the market and underperformance earlier this year likely helped as well.

Conversely, the sectors to which investors flocked for income earlier this year–Utilities, Consumer Staples, and Telecom–all lagged behind the S&P 500 in the last month. Here’s how the S&P 500 sectors performed since the market’s selloff began on August 16 through Tuesday’s close: Financials (-0.7%), Tech (-1.1), Energy (-1.9), S&P 500 (-2.9), Utilities (-3.3), Industrials (-3.5), Consumer Staples (-3.8), Materials (-3.9), Health Care (-4.6), Consumer Discretionary (-4.8), and Telecom (-5.7) (Table 1).

The change among the leaders and laggards is stark, as Telecom has moved from first place to last and Financials has done just the opposite. Here’s how the S&P 500 sectors performed from the start of the year through the August 15 peak: Telecom (19.5%), Utilities (15.2), Energy (14.0), Materials (11.8) Industrials (10.0), Tech (8.9), Consumer Staples (8.5), S&P 500 (7.2), Consumer Discretionary (4.9), Health Care (3.8), and Financials (0.5) (Table 2). Let’s take a look at how some of the S&P 500 industries have fared during this major sector rotation in the market:

(1) Climbing to the top. Many of the industries that led the pack going into the market’s August peak now are among the worst performers. The reverse holds true as well, i.e., the worst are best since the peak. As you’d expect given the strong performance of Financials, many industries in the sector were among the top 25 performing industries over the last month. The outperformers included Life & Health Insurance (4.0%), Regional Banks (2.7), Investment Banking & Brokerage (2.6), and Diversified Banks (0.7). Each was among the 25 worst-performing industries from January 1 through the market’s August peak.

(2) Remaining in the lead. Some of the industries that were among the top 25 performers from January 1 through August 15 were also at the top of the list during the recent selloff. The stalwarts include Oil & Gas Storage & Transportation, up 38.3% going into August 15 and up an additional 7.6% since then, Semiconductor Equipment (26.3%, 3.9%), and Casinos & Gaming (49.9, 0.0).

(3) Still in the doghouse. Conversely, some of the dogs continue to be among the worst-performing industries. For example, Specialized Consumer Services lost 27.0% from January 1 through August 15 and lost 9.0% from the S&P 500 peak through Tuesday’s close. Other chronic underachievers include Oil & Gas Drilling (-4.7%, -11.3%), Health Care Distributors (-4.1, -7.0), Health Care Services (-3.7, -6.7), and Home Furnishing Retail (-3.6, -6.9).

(4) Falling from grace. And lastly, some of the industries that were among the top 25 performing industries going into August 15 were among the worst-performing industries over the past month. Many of the industries in this last category are related to the housing industry, which may get dented if interest rates rise too far too fast. However, profit-taking also may have played a role in the weakness of some of the stocks that had the best performance going into the market reversal. Among the housing-related industries, Building Products was up 21.3% from January 1 through August 15 only to fall 8.7% since then. Similar action occurred in Construction Materials (34.3%, -9.2%), Household Appliances (25.9, -9.8), and Housewares & Specialties (24.5, -9.5).

After a strong run in the first part of the year, commodities also have fallen sharply in the past month. Diversified Metals & Mining, which rallied 79.8% through August 15, is down 16.6% since then. Steel was in the same sinking boat (28.0%, -10.8%). Gold, which is both a commodity, and is also interest-rate-sensitive, fell from its spot as the top-performing industry since the start of the year through mid-August, with a 149.7% return, to become the third-worst-performing industry, losing 13.1% since August 15. Kiss the summer doldrums goodbye.

S&P 500 Sectors II: See You in 2017. Some of the sector and industry rotation may be due to investors flipping the calendar to see what the future holds for earnings next year. True to form, analysts are forecasting strong S&P 500 earnings growth of 12.9% in 2017, a nice improvement from the meager 0.6% gain expected this year (Fig. 1). Joe and I are a bit more conservative, expecting earnings to climb 8.4%.

As we discussed above, the S&P 500 Financials stock index has had a strong run over the past month, perhaps bolstered by the strong earnings growth expected for next year. Financials are expected to post 9.8% earnings growth in 2017, up from a slight drop of -0.1% this year. Next year’s earnings jump likely bakes in expectations that the Federal Reserve will raise interest rates once before the end of this year. Financials industries with the most improvement expected in earnings growth for 2017 include Investment Banking & Brokerage, with earnings growth of 18.4% forecasted for next year, up from a 2.7% decline this year, Property & Casualty Insurance (16.7, -9.9), and Life & Health Insurance (14.1, -1.5) (Fig. 2). Stocks in those industries also performed well over the past month.

The Energy and Materials sectors have the largest expected gains in earnings growth next year, as 2016 comparisons are easy. Energy sector earnings are estimated to grow 292.0% in 2017 after declining by more than 50% in each of the past two years. The rebound in Materials isn’t quite as dramatic, with earnings targeted to grow 14.9% in 2017 after declining by single digits in each of the past two years. However, the recent drops in oil and materials prices have sent many stocks in those two sectors lower of late and may require analysts to lower their estimates if a bounce doesn’t occur before the end of this year or early next year (Fig. 3 and Fig. 4).

Analysts predict Consumer Discretionary, Tech, Health Care, and Consumer Staples sectors each will generate earnings growth of between 9.5% and 11.2% in 2017. In comparison, the low-single-digit earnings growth forecasted for both Telecom and Utilities appears paltry. Telecom earnings are projected to grow 4.5% in 2017, while Utilities’ earnings growth is pegged at 1.8%. Investors who once flocked to those sectors for safety and income may finally be tempted to shift to faster-growing sectors if it looks like earnings will come through as expected next year (Fig. 5 and Fig. 6).

Strategy: Frothless IPOs. A rash of IPOs can be a sign that the stock market is overheating. That happened in 2000 and again in 2007. And when the stock market cratered in subsequent months, so too did the IPO market. What’s notable this year is the low volume of IPOs even as the S&P 500 remains near record territory.

There have been 59 US IPOs priced ytd, down from 131 during the same period last year, according to Renaissance Capital. The drop is even more dramatic when compared to the recent peak year of 2014, when 275 IPOs were priced during the entire year. In fact, the new issue market in the first half of 2016 was slower only in two other time periods over the last 20 years–the first six months of 2009 and 2003–the 9/8 WSJ reported.

Part of the slowdown this year can be blamed on the poor performance of IPOs priced in 2015. The 2015 vintage IPOs lost 2%. But the returns have been far better this year, up 33% ytd, Renaissance Capital calculated. This year’s results were helped by the performance of three IPOs. Acacia Communications, a telecom equipment company, has returned more than 360% since hitting the markets in May. Not far behind are the 259.8% return of Twilio and the 154.3% return of Impinj.

As a result, Renaissance expected the pace of IPOs to pick up in the second half of the year–or at least it did before the market’s recent tantrum. By the time the year wraps up, Renaissance expects close to 100 deals to price. The market undoubtedly will have to calm down to hit that target.

Could the dearth of IPOs be a blessing in disguise? The 6/4 Barron’s noted that “[s]ince 2000, there have been eight calendar years with fewer than 100 IPOs. In the 12 months following each of those years, the Standard & Poor’s 500 index climbed an average of 13.1%, including dividends, according to data compiled by Jay Ritter, a University of Florida professor who has studied the IPO market for 35 years. In the 12 months following a strong year for IPOs—100 or more offerings—the S&P 500 lost an average of 1.2%.”

Technology: 3D’s Day? 3D printing stocks have performed miserably since the end of 2013, when industry hype hit a crescendo. Stratasys shares, which traded at $136.46 on December 20, 2013, closed Tuesday at $21.36. Likewise, 3D Systems’ shares traded at $15.16, down from $96.42 at the end of 2013. In addition to too much hype, the industry also suffered when the dollar’s appreciation and the downturn in China’s industrial economy hurt US manufacturers and depressed demand, ARK Investment contends.

Despite the false start, ARK projects revenue in the 3D industry will climb from $5.2 billion today to $41 billion by 2020 because the technology offers manufacturers a way to lower costs while increasing productivity and agility. That said, estimates from other firms are all over the map, ranging from a low of $12 billion by 2020 to a high of $490 billion by 2025.

Currently, the technology is used mostly to make prototypes, but it has the potential to be used for much more. GE uses more than 300 3D printers in its operation. Doing so has enabled GE to reduce the number of parts in a fuel nozzle from 19 to just one. Now the nozzle is 25% lighter and five times more durable. GE plans to invest $3 billion over the next five years in 3D printing and estimates that 100,000 parts will be manufactured by GE Aviation using 3D printing by 2020, ARK reported.

By using 3D printing, Nike reduced labor costs in footwear production by up to 50%, lowered material waste by up to 20%, and improved product performance due to lighter materials, ARK relays. Perhaps 3D manufacturing is the key to unlocking the manufacturing productivity gains that have been sorely missed in the current recovery.