As the headlines focus on the stock market and its constant weakness, it’s important to remember that the market’s returns are not uniformly bad. In fact, several sectors are positive,and understanding which sectors are strong and which are weak tells us a great deal about the market, the economy, and how average investors often fail to seethe forest for the trees.
First, the facts: five of the 11 S&P 500 components are in the green for 2018, albeit in Tech (XLK) and Real Estate (XLRE) the growth is modest: about 1% for XLK and 1.5% for XLRE. Stronger gains are in discretionary stocks (XLY) at 3.7%, Utilities (XLU) at 7.9%, and Health Care (XLV) at 7.6%. Communication services, a relatively newly defined sector of the market, is flat YTD.
The biggest losers are Energy (XLE), at 14.1% losses, and Materials (15.2%). This isn’t terribly new or surprising; energy has struggled since 2014, and this year was perceived to be a breakout for the sector.
The declines in these sectors tells us very little about fundamental economic performance, since energy’s weakness is oil price-related, and that weakness has been with us for nearly half a decade thanks to fracking resulting in massive energy supplies. Materials, similarly, is struggling from a major supply glut rather than weakening demand. So we can’t draw any bearish conclusions from these sectors specifically.
The same cannot be said for Financials (XLF), which is down 13.2%. There is one and only one reason for that weakness: the flattening yield curve. With tighter spreads, banks’ profitability is severely at risk, and the market is factoring that into financial firms’ prices. This is a bit of a change in trend, as XLF has been a solid performer over the last 5 years with a 41.4% gain (5th best of the 11 sectors). Higher interest rates were, theoretically, going to help XLF, but when the long end of the yield curve didn’t rise, that flat and near inverted curve led a lot of investors to bail on the sector.
Is that a trend we need to worry about in the future? In a word, yes. While some pundits and analysts are arguing that things may be different this time, an inverted yield curve is the most reliable and predictable recession indicator, and the 2-10 year spread has dipped to less than 20bps, the lowest since its inversion over a decade ago. That inversion, by the way, predicted the 2008 Great Recession.
So should we be worried or relaxed about the recent market weakness? In a way, economic fundamentals are strong across the board, whether you’re looking at earnings, revenue, investment, wages, employment, or almost any other indicator you choose (at least in the U.S.—the story in China and Europe is much more dire). With so much strong data, it is difficult to be bearish about the market despite recent volatility—and yet the flat yield curve encourages caution because of its strong track record. That divergence in indicators is a big driver behind the “this time it’s different” narrative that has gained currency on Wall Street. Whether it is or is not, a much closer look at sector-by-sector performance and fundamentals will help investors recognize when the market is ready for a substantial bear run—and the economy is ready for another cyclical downturn