In the five weeks since stocks hit levels that, for now, are the low point of the current bear market, there has been a shift in leadership among the best performing sectors.
For most of the first half of 2022, the only sector posting gains was energy, with utilities living up to its defensive reputation and posting the smallest losses among the remaining 10 sectors.
But since June 16, cyclical tech and consumer stocks have been the leading sectors after being hit harder than the rest of the market in the first half of the year. Stocks leading the rebound include Amazon (AMZN)You’re here (TSLA)Home Depot (HD)and McDonald’s (MCD).
But the jury is out on whether this is simply a relief rally or a more lasting trend.
“We can see a volatile stock market that tends to show shifts in sentiment through rotations in sector leadership,” said Invesco’s chief global market strategist. says Kristina Hooper. However, Hooper warns that “this may not be predictive of the future” and says, “we are getting mixed signals.”
Since hitting their lows, stocks have been reacting to an easing in inflation expectations, Hooper says. But the key determinant to which sectors lead in the coming quarters, and whether the stock market has bottomed out, will depend on the economic backdrop and the Federal Reserve’s actions on interest rates. Right now, “it’s hard to figure out where we’re going from here,” she says.
At a market low on June 16, the Morningstar US Market Index has fallen 23.9% this year. The index has since gained 8.6%, with a third of the rebound attributed to technology stocks and a fifth to the consumer discretionary sector.
Since then, the Morningstar US Consumer Cyclical Sector Index has led all others with gains of 7.5% through July 20, while the Morningstar US Technology Sector Index is up 7.0%.
This marks a tidal shift in markets, as cyclical consumer stocks fell the furthest of any sector in the first half of the year through June 16, down 34.7%. Tech stocks fell 32.1%.
A boost from lower inflation expectations
Hooper sees the rebound in equities being driven by lower inflation expectations in the US Treasury inflation-protected securities market.
The TIPS market provides a window into where people think inflation is heading through the equilibrium rate, which compares TIPS returns to their non-inflation-adjusted counterparts. The equilibrium rate is essentially the expected rate of inflation for the period covered by the bonds.
The 5-year break-even inflation rate fell to 2.67% on July 20 from a peak of 3.60% at the end of March. Its current levels are much closer to the Fed’s long-term policy target of 2% inflation.
Since the market bottomed in June, three of the five best performing industries in the market have come from the technology sector. “Any kind of easing in rate hike expectations can be positive for tech stocks,” Hooper said.
A temporary relief rally
Consumer electronics stocks, companies that make and sell audio-visual equipment, rose 18.5%, led by Apple (AAPL). The software infrastructure industry, which includes companies that develop and supply products for various business applications, gained 8.3%, as Microsoft (MSFT) gained 7.1%. Semiconductor industry grew 11.0%, led by Nvidia (NVDA).
Hooper notes that some tech companies are starting to make cautious cost-cutting decisions, such as hiring slowdowns.
“Big, fundamentally sound companies keep their finances in order,” she says. “Investors are reacting positively to these decisions.”
Nuveen Chief Investment Officer Saira Malik says big tech companies with strong fundamentals can perform as defensive stocks. “Early on in the coronavirus pandemic, people bought tech stocks that could continue to grow even when there was very little economic growth,” she says. “Given the Fed’s aggressive rate hikes, it’s too late to avoid a recession. But big tech moves can provide security.
Yet Malik sees the sector’s recent rotation as “a “temporary relief” rally with more bear market volatility ahead.
“It’s not a market bottom,” says Malik. “Things aren’t going to get steadily better from here.” Signs of a bottom include stronger signals that inflation won’t continue to rise and strong economic data, Malik says. “Right now, we are still in a period of volatility.”
More than a bear market trap
Jim Paulsen, chief investment strategist at Leuthold Group, thinks the management rotation is consistent with the idea that the worst declines of the current bear market are behind it.
“A lot of smart people think the current market rally is a bear market trap, but I think we’ve had our crescendo sell off,” Paulsen said. “We are seeing a decisive return to technology and other growth stocks.”
In the background, “the economy is changing its stripes toward slower growth, slower inflation and fewer interest rate hikes ahead,” Paulsen said.
“Gasoline prices at the pump are going down and people are starting to notice that,” he says. “It indicates that the Fed could become a little less aggressive in its tightening.” Paulsen says a slowdown in interest rate hikes means less pressure for tech stocks.
Tech stocks are particularly sensitive to rising interest rates due to their potential for future earnings. High-growth tech stocks “are hit harder than value by interest rates because their cash flows are further into the future.” During the first half of the year, as the Fed continued aggressive interest rate hikes, tech stocks fell more than the broader market.
Despite the uncertainty, Invesco’s Hooper notes, “The Fed is driving this market environment. Looking at the data influencing the Fed gives us an idea of the direction,” she says. “It will help confirm where stocks are going next.”