Market & Economic Commentary

Small-caps are gaining traction as light appears at the end of the COVID tunnel

After a long period of either underperformance or mixed relative returns, small-caps in the US are now finally gaining meaningful traction relative to large-caps.

As shown below, the relative return of the small-cap Russell 2000 index versus the large-cap Russell 1000 index has broken out of the range it has been in since June. The latest move started after the Pfizer vaccine news hit on November 9th, after making an initial move in early October.US Small-Cap Large-Cap Relative Return

Our view has long been that small-cap relative performance follows a cyclical pattern, with the best return/risk payoffs coming when the economic and market cycle have been weak and are starting to recover. The early stages of a new expansion or bull market are thus typically the best for small-caps, while the later stages of an expansion or the early phases of a bear market or recession tend to be better for large-caps, especially after accounting for risk.

The current economic cycle has been very unusual. After a record-long expansion, a very rare external shock (a virus) hit, causing far higher amplitude in the economic data (record-setting declines and recoveries), along with historically huge policy interventions (fiscal and monetary stimulus, etc.). The heavy uncertainty about how the current cycle will play out may explain why small-cap relative performance has only recently started to show the upturn we would expect as conditions start to improve after a recession. The recent signs of progress on a vaccine (or multiple vaccines) offer the prospect of “getting back to normal” next year, and may reduce some of the headwinds facing smaller companies relative to larger firms.

Several other indicators suggest the small-cap outperformance trend may be a better bet now than earlier this year.

First, US small-caps are outperforming across all sectors over the last month, indicating a broad-based trend. This includes the Technology sector, where large-cap Tech had outperformed small-cap Tech by 30% for the year through September 1st, but since then small-cap Tech has outperformed its larger brethren by 12%.

Second, as shown below, the “volatility penalty” for owning small-caps has declined and is now back to relatively low levels. The rolling three-month volatility of the Russell 2000 index has now fallen back to just a small differential over the volatility of large-caps (Russell 1000). That is, investors do not have to take on substantially more risk (volatility) in their portfolios by choosing small-caps over large-caps, as they would have done earlier in the year.US Small vs Large-cap Relative Volatility

And third, small-caps outside the US have been outperforming for some time now (as shown in the lower two sections of the chart below), and therefore US small-caps may have some catching up to do.Global Small-cap Relative Returns

With price activity looking better and the cyclical backdrop potentially becoming more favorable, there could be more room for the recent trend of small-cap outperformance to run over the coming months.

Vaccine news brought record style rotation in stocks

The headlines on Monday (Nov. 9th, 2020) from Pfizer announcing favorable early results in their COVID-19 vaccine trials, while certainly welcome, clearly caught investors off guard. While the major indices were either up or flat on the day, there was a historic level of divergence within the market among the various styles and sectors.

Such extreme rotations remind us that there is risk in the equity markets even when stocks overall do not fall. Investors focused on relative performance likely either had a huge win or huge loss on Monday.

The charts below give some perspective. We highlight returns to widely-used market-neutral factors (styles) that were most impacted yesterday: price momentum, value, and size (small-caps).

The first chart below shows how extreme the returns on Monday were in historical context. We use the daily returns of the Dow Jones Thematic Market Neutral indices for the three styles, data for which goes back to 2002. These indices assume equal dollar amounts invested in long and short portfolios (netting out to zero, or “market neutral”) based on the standard textbook definitions of price momentum (which favors stocks that have outperformed over the last 12 months), value (which favors stocks that have low multiples of price to book value, earnings and cash flow), and size (which favors stocks with lower market capitalizations). The indices are rebalanced quarterly.

Dow Jones Thematic Style Indices Daily Returns

The market-neutral Momentum style had the biggest move on Monday among these indices: a daily return of -14%, the largest daily movement (up or down) in the history since 2002. The next most negative day (April 9, 2009) was a -7% return, so Monday was twice the magnitude of the next-worst day. The biggest positive return historically (April 20, 2009) was +10%. The normal range for daily returns since 2002 (where 95% of observations have fallen) has been -1.3% to +1.3%. So Monday’s Momentum return was extraordinarily extreme.

The Value style was one of the big winners, showing a market-neutral return of +8% for the day on Monday. Before this week, the Value factor’s biggest gain was earlier this year (May 26th) at 4.4%, so Monday’s return was almost twice the next-largest move (the biggest decline was similar at -4.3%). The normal range for daily returns for Value since 2002 has been -0.9% to +0.9%.

The Size style also had a big day, showing a +4.5% return, meaning small-cap stocks outperforming large-cap stocks by nearly 5%. This basically matches the previous maximum return of +4.7% from March of this year. The Size factor has had a similar typical daily range as Value (+/- 0.8%).

However, context is important here. These extreme moves in styles essentially constitute reversals of the general trend they’ve shown most of this year. Momentum had been one of the stronger styles until this week, while Value and Size had been performing poorly. The second chart below shows the indices themselves (rather than daily changes) over the last 12 months.

Dow Jones Thematic Style Indices

We see that market-neutral price Momentum had posted a return of +36% over the 12 months through November 6th, so Monday’s drop cuts into that gain but still leaves the strategy with a positive return for the last 12 months.

Value, by contrast, had been the reverse: it had shown a -37% return (market neutral) through November 6th, so Monday’s gain helped but leaves the style still significantly negative over the last 12 months.

Size (small-caps) had also underperformed coming into this week, showing a -16% return through November 6th. Thus the 4.5% gain reduces the 12-month loss, but still leaves small-caps lagging large-caps by a wide margin over the last year.

The question remains open as to whether Monday’s sharp reversals in relative performance within the major equity market styles (and related sectors) mark the beginning of a durable new trend, or a short-term positioning event that will reverse like a similar event in May/June of this year. Further developments in COVID-19 vaccines, fiscal stimulus plans, and corporate earnings will likely help answer that question, but the uncertainty surrounding these developments means that elevated internal volatility and rotation in stocks may well continue in the coming months.

Politics aside, earnings estimates are still improving

While the headlines and market reactions are dominated by the US election results right now, it is worth keeping in mind the news on corporate earnings trends. More than 75% of companies have now reported Q3 earnings, and the results have been extremely strong relative to expectations. The results have not, however, been immediately greeted with positive price responses. Market action being attributed to the election may also be influenced by a lagged response to earnings reports.

According to Factset, within the broad S&P 1500 index universe (large, mid, and small-caps), 84% of companies have reported positive surprises (earnings ahead of consensus estimates) for Q3 so far, and the average “beat” has been quite large in percentage terms. Whereas the consensus forecasts expected S&P 1500 earnings to be down about -25% from a year prior in Q3 when the quarter started (July 1st), the actual results look like they will be around -8%: still down, but far less than expected.

However, Factset’s calculations indicate that only 48% of stocks had a positive stock price impact immediately after their report. Worries about the election and the prospects for further fiscal stimulus in recent weeks may have dampened investor responses to what would otherwise be favorable corporate earnings news. With some of the political uncertainty in the process of being resolved now, investors may now be willing to reward positive earnings news.

So how are analysts responding to the corporate news flow with regard to their forward earnings estimates for the next 12 months?

Our data show that analysts continue to show significantly more estimate increases than decreases in the US, and increasingly that is true for the lagging developed ex-US (EAFE) universe.

The charts below show our indicators of analyst estimate revisions activity in the US and EAFE markets (Europe, Australasia and Far East, i.e., developed ex-North America markets). The red line is the average net proportion of analysts raising versus lowering earnings estimates (right scale), and the blue bars indicate the average percentage change in next-12-month (NTM) estimates over the last month (left scale).

United States_AbsERS_5Nov2020

EAFE Markets_AbsERS_5Nov2020

We see that the US estimate revisions indicators shifted dramatically from severely negative in the spring amid the initial COVID-19 lockdowns to positive over the summer (starting after Q2 earnings reports) and have recently accelerated further to their highest readings in many years. This reflects the impact of the massive stimulus programs started in April and continued through the summer, but which are now fading. It also reflects the heavily conservative estimates that analysts made amid the extreme uncertainty around the impact of COVID-19 and the lack of corporate earnings guidance: with much less information to go on and plenty of unprecedented events, they took a very cautious view on their earnings estimates. Thanks to stimulus and other measures (forbearance on debt repayments, evictions, etc.), earnings have been better than those pessimistic estimates.

A similar pattern has played out, to a somewhat lesser extent, outside the US, where growth was already somewhat weaker than in the US and stimulus efforts were more mixed. This is partly due to the issues in Europe where coordinated fiscal policy is more difficult to do, and the fact that interest rates were already zero or negative in most of the region and thus couldn’t be lowered much more. The same is true to some degree in Japan. And while the US election will be resolved one way or another in the coming days and weeks, the impact of Brexit on the UK and Europe remains an ongoing risk factor.

The recent trend in analyst estimate activity thus remains favorable, but faces risks from the current upswing in COVID-19 cases in the US and Europe as well as the timing and scope of any further fiscal support for economies. Thus choppy market action with an upward drift continues to look most likely, with significant rotation under the surface of the major indices.

Big divergences in commodity space still favor Materials over Energy

One of the themes in our sector research for clients recently has been to focus on relative preferences within broader style or macro categories, rather than making big macro bets on Growth versus Value or Cyclical versus Defensive areas. We find that in a more range-bound market with conflicting macro trends, a more granular view is often more effective.

One stance we have held for some time has been within the Value-oriented commodity space. While in many cases historically the Energy and Materials sectors have moved together, this year has seen a dramatic divergence between the two commodity-related sectors. We have favored Materials over Energy this year, and still do, and below are some of the drivers of that view.

The first chart below shows the returns of the S&P 500 Materials sector and the S&P 500 Energy sector for this year, along with the relative performance (all indexed to 100 at the start of the chart), as of October 27th.SP500 Materials vs Energy Sector Returns

The collapse of the Energy sector this year has been historic, and comes after less extreme underperformance that was already occurring in 2019. The S&P 500 Energy sector total return index has declined -50% this year, by far the worst performing of the 11 major sectors in the S&P 500. This compares to the 6.5% gain for the S&P 500 overall.

The Materials sector, despite also being tied to global economic turbulence and commodity prices, has held up far better. Its year-to-date gain of 5.6% is only marginally behind the overall index, and vastly higher than that of Energy. And the relative outperformance trend has been consistent most of the year, both before the COVID-19 volatility in March and afterwards.

What explains the performance gap in these two commodity sectors?

First, the underlying commodities they are most closely tied to have followed very different paths this year. Crude oil prices are still far below their level at the start of the year (down about 40% for benchmark Brent crude), and even the current level of oil prices relies on the aggressive production cuts put in place by oil producers globally. So oil producers are facing the combination of lower prices and lower production, causing a severe drop in revenues. Naturally, the effects of severely depressed fuel usage due to COVID-19 travel limitations are a major factor in oil demand, and remain in place.

By contrast, industrial metals prices such as copper, aluminum, zinc, etc. (represented by the S&P/GSCI Industrial Metals index) have fully recovered their COVID-related decline and then some. Resurgent demand from China in particular as well as the strong US housing market have helped support prices for these metals used in manufacturing and housing, and are benefiting from the reflationary efforts of global central banks. Along with the increases in precious metals prices (gold and silver) this year, many of the stocks in the Materials sector have a relative tailwind to earnings from commodity prices.

Oil Industrial Metals

The effect of these divergent commodity price trends is also showing up in relative earnings estimate revisions activity. Analysts have been much more inclined to raise their earnings forecasts for Materials companies than for Energy companies, and that remains the case today. The chart below shows our aggregated relative earnings estimate revisions metrics for Materials versus Energy in the US. Readings above zero on the chart indicate more favorable analyst estimate revisions trends in Materials relative to Energy (red line indicates the relative proportion of analysts raising vs. lowering estimates, right scale; the blue bars indicate the average relative percent change in consensus estimates for the next 12 months, left scale). We can see that the readings are strongly in favor of Materials over Energy and have been for several months now.

US_Sect_RevSpread_Materials_Energy

With fundamental trends and relative returns both still pointing toward Materials over Energy within the commodity space, we would maintain relative positioning along those lines.

Housing has been strong, but mortgages are harder to get

By some measures, the US housing market has been extremely strong. Sales of new homes are up more than 30% year-on-year, as many people are seeking to leave big city centers and buy single-family homes in the suburbs.

However, the chart below shows some of the extreme and offsetting influences on the housing and mortgage markets right now.

Mortgage and Housing Indicators

Mortgage rates have plunged to all-time lows (top section in the chart), reducing the payments needed to buy a house with a mortgage. This has led to a surge in mortgage purchase applications (second section).

While higher demand has pushed prices for houses up to a new high ($310K median for existing homes, third section), that demand is also running into the corresponding fact that many people who already have houses do not want to sell right now. So the supply of houses on the market has plunged (fourth section).

Lower mortgage rates have helped improve the housing affordability index (fifth section), but rising prices have now limited the improvement. Affordability is much better than in 2018 and similar to its level in 2014-16.

We cannot forget, though, that the economy is still very weak and employment is still far below pre-COVID levels. This means that there are likely fewer credit-worthy borrowers, and banks have tightened conditions for loans of all types significantly this year.

Indeed, the last section of the chart shows the Mortgage Bankers Association Mortgage Credit Availability Index. It measures availability of mortgage loans based on underwriting standards used by lenders. Higher readings indicate greater availability of mortgages. The plunge in the index this year reflects the dramatic tightening of lending standards for mortgages (e.g. requiring higher credit scores and income standards, lower loan-to-value, etc.). So while many people are applying for mortgages, a greater number are also likely not being approved and actually getting the loans. Houses are popular and appear affordable IF you can get a mortgage (or don’t need one).

Online shopping trends remain a key driver of equity returns

The growth of online shopping has been well-established for years now, but the pandemic has prompted an acceleration in that trend, which continues to be felt in relative stock returns.

The chart below shows the year-on-year growth rates of total US retail sales and online retail sales (non-store retailers) over the last five years (based on monthly retail sales reports from the US Census Bureau). We can see that online sales have been growing significantly faster than total sales the entire time, and most notably, are now near their highest growth rate (20%+) even as total retail sales dropped sharply earlier this year and are currently roughly unchanged from year-ago levels (indicating that non-online sales are down from a year ago).

The bottom section of the chart plots online sales as a percentage of the total. While there are seasonal swings in the monthly data, the 12-month average shows a clear upward trend over the last five years, with a distinct acceleration most recently. In the last five years, online sales have grown from less than 10% of all sales to almost 15% (on a 12-month basis), and briefly surged to 18% amid the lockdowns earlier in the year. Online and Total US Retail Sales Growth

The reasons for the shift to online shopping during the pandemic are mostly obvious, as the ability to shop in physical stores was sharply limited in many areas due to lockdowns and worries about the coronavirus. This is, however, another example of a trend that was in place well before COVID-19 arrived, and has simply accelerated. While store-based retailers may take back a bit of share near-term, the longer-term trend towards online shopping (at least for things that can be bought online) and entertainment services like video games looks likely to continue.

What about the impact on stock prices? The year-to-date returns to some industries in the broad S&P 1500 Supercomposite Index that are closely tied to these trends make the point (example constituents are shown for reference in parentheses — these are not recommendations to buy or sell). For comparison, the S&P 1500 index has returned 8.6% for the year-to-date.

  • Internet & Direct Marketing Retail (Amazon, EBay, Etsy): +71%
  • Air Freight & Logistics (FedEx, UPS): +54%
  • Interactive Home Entertainment (Activision Blizzard, Electronic Arts, Take-Two Interactive): +32%

One clear loser has been commercial real estate, especially the REITs (real estate investment trusts) that own retail space (malls, etc.) that rely on store-based retailers. Department stores make up many of those, and have been hurt badly, as have some of the companies that make the products sold in stores, particularly fashion clothing and accessories.

  • All REITs: -9%
  • Retail REITs (Simon Property Group, Regency Centers, National Retail Properties): -40%
  • Department stores (Macy’s, Nordstrom, Kohl’s): -62%
  • Apparel & Accessories (VF Corp., Ralph Lauren, UnderArmour, Movado): -28%

The impact of the shift to online buying is ongoing, as is the impact on company earnings forecasts and stock returns. While in-person shopping will always be there, it seems that there is scope for further shifts toward online shopping, and finding the winners and losers from it will likely remain important even after the impact of COVID-19 has eased.

Putting the Fed’s balance sheet in perspective

Along with fiscal stimulus, the aggressive support of financial markets by the Federal Reserve (and other central banks) has been a key to the gains in risk assets since April. In our view, stock and bond prices would not be as high as they are if not for the perception that the Fed will step in with additional support if markets get too volatile. This perceived “Fed put” is on top of the ongoing bond buying programs (excluding the immediate post-COVID surge) that are currently running at a rate of about $80 billion per month for Treasuries and $40 billion per month for mortgage backed securities, though some of this replaces expiring bonds.

So the Fed continues to have a heavy influence on debt markets, and thus indirectly on equity and other financial markets.

The size of the Fed’s balance sheet (the value of all assets it holds) used to be far smaller relative to the economy or the markets, and only began to be a major part of the monetary policy toolkit in 2008 in response to the Great Financial Crisis. Previously, the Fed’s control of short-term interest rates was sufficient and did not require as much balance sheet activity, but once short-term policy rates hit zero in 2008 (and again this year), new tools were needed.

The chart below plots the ratio of the Fed’s balance sheet to US nominal GDP, perhaps the most common way of putting the Fed’s monetary policy actions in perspective. From a pre-crisis level of around 6% of GDP in 2007, three rounds of quantitative easing (“QE”, or bond buying) starting in 2008 pushed the ratio up to about 25% of the size of the US economy in 2014. Then the Fed allowed some assets to “roll off” (bonds maturing and not being replaced with new ones) and effectively shrink the balance sheet relative to the economy. Several years of such a policy brought the balance sheet back to about 18% of GDP in early 2019.

Fed Balance Sheet Pct of GDP

This appears, in hindsight, to have been too small a size for the Fed’s balance sheet nowadays. It is important to recall that even before COVID hit earlier this year, in mid-2019 the Fed began lowering rates and adding to its balance sheet again to ward off interbank funding strains and signs of weakening economic growth. Then in response to the COVID-related shutdowns of the economy, the Fed made its most aggressive balance sheet movement to date. It bought nearly $3 trillion in Treasury, mortgage-backed, and other bonds very quickly, pushing its balance sheet size up to its current record level of about $7 trillion. This is now about 36% of US GDP.

While comparing the Fed’s assets to the size of the economy is a relevant comparison, we should also keep in mind that financial markets have generally grown faster than the economy. So it is also worth considering the Fed’s balance sheet in relation to the size of the debt and equity markets.

Notably, even with huge issuance of Treasuries recently to finance the US federal budget deficit, the Fed now owns over 20% of all publicly held Treasuries, more than it has in at least 20 years.

And it owns more than 30% of the mortgage-backed bond market, similar to what it owned in the aftermath of the Great Financial Crisis (which was heavily tied to the mortgage and housing market). This has helped push mortgage rates to all-time lows recently.

The chart below, however, plots the Fed’s balance sheet relative to the size of the US equity market. Now, to be clear, the Fed does not own US stocks (at least not yet, though other central banks like those in Japan and Switzerland do buy stocks), so this is just another way to scale the size of the Fed’s balance sheet (bond holdings) that may be of more interest to equity market participants.

Fed Balance Sheet Pct of US Market Cap

We compare the value of the Fed’s assets to the total equity market capitalization of the broad Russell 3000 index (the 3000 largest US companies). The picture there is notably different than the one using GDP as the scaling metric.

The initial surge in 2008-09 is very stark, pushing the balance sheet from around 7% of equity market cap up to a peak around 25%. Then the balance sheet oscillated around 20% of US equity market value as the Fed’s bond buying was roughly in line with the growth in the equity market through 2016. When the Fed began allowing its balance sheet to gradually decline, stocks continued higher and thus the Fed’s assets dropped sharply to a low of around 13% of equity market cap in 2019.

The Fed’s actions this year have provoked another jump in the ratio, but the change relative to the stock market has been less than that seen in 2008-09, due to the larger size of the stock market. The peak earlier this year was around the same 25% level relative to US equity market value, and since then the gains in stocks have outpaced the Fed’s buying of bonds and pushed the ratio back down somewhat.  The Fed’s assets now equal about 21% of US equity market value, not far from the average level during the 2009-2016 period. This reflects the fact that the stock market has grown significantly faster than US GDP in recent years as equity valuations have risen.

We can thus see that while the Fed is more involved than ever in financial markets by some metrics, by others it is not far from the ranges it has inhabited since the Great Financial Crisis started 12 years ago. And we should keep in mind that other central banks (Bank of Japan, European Central Bank) have balance sheets even larger relative to their economies or their financial markets. So the Fed could certainly continue expanding its asset purchases further before it would approach the relative size of some of its counterparts.

The Fed is thus both limited and nearly unlimited: it can print money to buy bonds (including corporate bonds now), i.e., make loans, in almost unlimited quantities, but cannot determine how the money they print is used (or not used), and cannot give outright gifts or grants. Only Congress, via the Treasury, can distribute truly “free money” that does not have to be paid back. And recent headlines suggest further delays in new fiscal policy support. That leaves the Fed as the main provider of market support, at least for now.

Tech Sector In The Driver’s Seat For US Relative Performance

In this post, we highlight the interaction of US outperformance versus the rest of the world this year and US Technology relative to Ex-US Technology.

  • First, the relative performance of the US equity market versus the rest of the world has been highly correlated with the relative performance of US Technology stocks relative to Ex-US Technology stocks.
  • Second, the outperformance of US Technology, and by extension the major US indices versus their non-US counterparts, looks likely to continue based on relative earnings estimate revisions patterns.

The chart below supports our first point. The US has outperformed the rest of the world this year by a healthy margin, based on the MSCI regional benchmark indices, as shown in the top section (plotted using rolling five-day averages). The lower section isolates the Technology sectors for the US and the Ex-US universe (also using MSCI indices) and plots the relative return of the US versus Ex-US Technology sectors.

US vs Ex US and Technology Relative Returns

We can see the close parallels in the charts for the year-to-date: as US Tech outperforms Ex-US Tech, so does the broader US market outperform the Ex-US aggregate. This in some ways seems unsurprising given the heavy weight that the Tech sector holds in the US compared to many non-US markets, but the relative weights are unrelated to the relative performance of the US versus Ex-US Tech sectors. We find that even after removing the effects of sector weightings, US stocks have outperformed Ex-US stocks this year, and this effect is particularly strong within the Technology sector.

Our second point is captured in the chart below. It shows our measure of aggregated earnings estimate revisions (the percentage of analysts raising versus lowering earnings estimates) for the US Tech sector and the entire Global Tech sector (which includes the US).

Technology Sector Revisions Breadth Metrics

We can see here that earlier this year, US and Global Technology estimate revisions (fundamental trends) were mostly moving closely together and slightly favored non-US Tech (US Tech revisions were slightly weaker than Global Tech revisions).  Both revision metrics improved sharply from the April lows through today. But the difference between the US and the Global Technology sector earnings estimate measures moved dramatically in favor of the US in July after Q2 earnings reports came out, and have generally remained there ever since. This suggests that US Technology stocks have a strong fundamental tailwind relative to Tech stocks outside the US right now. If that US Technology tailwind persists, the broader US market seems likely to resume outperforming the rest of the world in the coming months.

Does The NASDAQ-100 Correction Have Further To Go?

The NASDAQ-100 Index (often known by its ticker symbol, NDX), home to many of the mega-cap Tech-related Growth stocks that have dominated the US stock market this year, has seen some corrective action this month. A common question we hear is: is the correction enough to say the NDX is no longer “stretched” after its historic surge through the end of August?

The chart below provides some context. For four different indices, it plots the percentage difference between the current index level and its 200-day moving average, a common measure of the longer-term trend. Excessive deviations from the 200-day average are often viewed as signals of extreme investor behavior that are likely to revert back toward the average.

The chart includes the NASDAQ-100 (NDX) along with other major indices that do not include the mega-cap US Growth stocks that influence the NDX: the Russell 1000 (large-cap) Value index (“R1K Value”), the Russell 2000 small-cap index (“R2K”), and the MSCI All-Country World Excluding US Index (“ACWI Ex-US”).

Major Index Pct from 200 day MA

For much of the last 5 years, all of these indices typically traded within a range of +/- 10% of their 200-day average, with outlier declines visible in early 2016, late 2018, and of course March 2020.  Movements of more than 10% above the 200-day average were relatively rare, at least until early 2020 and again in mid-2020 for the NDX.

Indeed, the divergence between the NDX and the other major indices became quite stark this year, and remains so today. The NDX’s surge through August brought it briefly to more than 30% above its 200-day average, an extreme reading for any major index historically. The other indices showed nothing at all similar, only recently even managing to rise above their own moving averages, and none by more than about 8% at most.

So even after a correction in the NDX of about 12% from the peak and a modest recovery, the index is still 16% above its 200-day average. That is, even after a notable correction, the index’s divergence from its longer-term trend is still sufficiently extreme that it would be considered “overbought” or excessive by normal historical standards for major indices. By contrast, as of the close of Sept. 22nd, the other three indices in the chart were within a range of 1% below to 3% above their own 200-day averages, i.e., hovering very close to their respective longer-term price trends.

This metric by itself would indicate that the NDX is still at risk of further corrective action in order to move back to a more normal distance from its 200-day average. Of course, if the fundamental earnings trends for the NDX constituents are indeed that much stronger than those of the other indices, then a persistent gap could be warranted. And it is worth remembering the “moving” part of a moving average: the gap between the index and its moving average will narrow even if the index is simply unchanged for a period of time as the moving average catches up to the current price.

Our guess would be that the “easy money” period may be over, and there will be more choppy activity that narrows the gap between the NDX and its moving average, but doesn’t necessarily result in a massive decline from recent levels. We expect fundamentals for the large-cap Tech/Growth stocks to remain attractive in relation to other areas of the market on a longer-term basis, but the excessive optimism in the NDX seen around the peak in late August needs some time to be worked off.

Growth leadership easing as rotation increases

One of the most notable market trends in recent weeks has been the corrective action in the formerly high-flying US large-cap Growth stocks. The dominant Tech-oriented companies that have been responsible for much of the gains in US large-cap indices for several months finally saw some significant selling pressure in the first two weeks of September.

The first chart below shows absolute and relative returns for the S&P 500 Pure Growth and Pure Value indices (i.e., the style indices restricted to stocks that fall entirely into their indicated style, leaving out those with weight in both indices).

SP500 Pure Growth Value Indices

Key points:

  • The Growth index has been above its 50-day moving average since mid-April (and made new highs recently), but has now returned to that average after its recent correction. Any further declines could raise worries about an intermediate trend change.
  • The Value index has failed to even approach its January highs and has made little net progress since early June. It is also sitting near its 50-day average.
  • Growth/Value relative returns show little net change in the last two months, following a period of drastic Growth outperformance. This is consistent with our recent sector allocation recommendations to clients that have reduced style-level sector bets in favor of intra-style differences.

Corroborating the Growth/Value trends is the relative performance of the Growth-heavy Technology sector’s returns. Below is a chart showing our broad (300+ constituents), equal-weighted US Technology sector performance relative to the broad (2000+ constituents) US aggregate.  

US_Technology_RelPrice_Daily

We can see that after a period of sustained outperformance through the middle of this year, the relative returns for Tech have been much more mixed, and have dipped lately. Investor optimism toward Technology has shown signs of reaching extremes recently, and thus some corrective action is not surprising.

We continue to expect Technology to be a leading sector on an intermediate-term time frame, but both the sector and the overall market may have to go through further choppy trading activity and rotation near-term.