- Stocks were positive in July despite weakness near month-end and a lack of tech leadership.
- In a reversal of recent trends, large cap outperformed small cap and value beat growth
- Industrials, Healthcare and Financials outperformed
- Rate sensitive Telecoms, Utilities and REITs underperformed
- Earnings growth and beat rates are exceeding expectations in the reporting season so far
- Tech, which has been leading the market since late 2016 had middling performance in July
Index & Sector Performance:
Equity markets started off the second half of 2018 on a positive note led initially by the Nasdaq Composite and Nasdaq 100 indices - each of which registered fresh all-time highs - as the S&P500 itself made a bullish breakout above a five month resistance zone at the 2,800 level. However during the final week of July things reversed course amidst heavy selling within the technology sector, particularly in the social media space, resulting in divergences and failed breakouts amongst many extended leaders. While index and sector performance were largely positive for the month on the back of strong corporate earnings and accelerating economic activity, a number of ongoing developments underneath the hood of the stock market reflected a rotation in leadership towards previously underperforming sectors which for other groups may suggest a deeper and /or longer correction is at hand.
For the first time in 2018 the Dow Jones Industrial Average (INDU) led all major indices in monthly performance with a gain of 4.7% bringing its YTD return back into the green, +2.8%. The S&P 500 (SPX), Nasdaq 100 (NDX), and Composite (CCMP) indices followed with gains of 3.6%, 2.7%, and +2.2%. The smaller sized indices underperformed as the S&P Midcap 400 and Russell 2000 each returned 1.9%, while the Russell Microcap Index, the leader over each of the prior two months, finished down a modest (0.1%). Perhaps the most impressive performance was that of the Nasdaq 100 (NDX) which despite experiencing three consecutive declines of 1.4% in the final week of July, still managed a robust 3% gain for the month. From a technical perspective, despite the end of month weakness the NDX still managed to hold above both its 50-day moving average and three month rising trend line.
Among the primary GICS sectors, industrials were the top performing group with a sizeable monthly gain of 7.3%, followed then by healthcare +6.5%, financials +5.1%, and staples, +3.9%. All four groups meaningfully underperformed the broader market through the 1H of 2018 as healthcare was the only one in the green over this time with a modest 1% gain. Technology finished July in the middle of the pack but still managed a more than respectable 2% gain despite meaningful declines amongst a few high profile members. The bond proxy Utilities and REIT sectors underperformed with gains 1.8% and 0.9%. Discretionary came in at +1.7% for July and overtook technology as this year’s top performing sector, +12.7% YTD.
As mentioned the industrial sector was by far July’s top performer, +7.3%, as manufacturing and transports benefitted from late month optimism on trade. Although trade war rhetoric has been volatile throughout much of 2018 as the administration seeks out bilateral trade deals over multi-lateral agreements, a meeting between Trump and European Commission President Juncker ended with a commitment by both sides to increase Transatlantic trade. There was also late month optimism that a trade deal could be reached directly with Mexico, as the two countries engage in bilateral discussions to the exclusion of Canada. Industrials gained another 2.1% on the final day in July following reports the U.S. and China are aiming to restart trade talks in order to avert a full blown trade war between the world’s two biggest economies. From a technical perspective the industrials have broken out from the declining trend line in place from the Early February highs and are now in the early stages of confirming a bullish “double bottom” reversal pattern.
Health of the Markets: Healthcare stocks had a strong July, and the S&P 500 Healthcare Index (S5HLTH) is the third best performing S&P 500 sector YTD. The S5HLTH Index gained over 6.7% for July, following a 1.6% in June for an impressive total return of 8.4% for the two months making it the second best performing sector for this time frame trailing only the Consumer Discretionary sector. Not to be outdone, the Nasdaq Biotech Index (NBI) returned 6.15% in July and 1.4% in June for a 7.6% return for that period. The S&P 500 Index has returned 3.75% for July and only 4.4% since June 1st. The Nasdaq Composite returned 2.3% in July and 3.3% since June. Clearly healthcare has ticked up the last few months after beginning the year flat. YTD, the S5HLTH Index is up 7.56% making it the third best performing sector of 2018!
The S&P Financials Index was strong throughout the entire month of July by finishing four consecutive weeks in the green for a monthly gain of 5.4%. The group is viewed by many generalists as the plumbing of the U.S. economy and thus a barometer of economic activity. In that regard the sector’s decline of (4.9%) through the 1H’18 had been a bearish divergence relative to the strong economic data and corporate earnings as evidenced by Q2’s 4.1% GDP figure, a near four year high. The rebound in early July was sparked when the Federal Reserve allowed two large Wall Street banks avoid some of the consequences for failing part of the recent “stress test”, which minimized their reduction in payouts, and thus was seen as part of the new era of more lax bank regulation. This was soon followed by solid earnings reports by a number of the nation’s largest banks reflecting solid loan growth, widening margins, and healthy capital markets revenues. The financials index is now flat YTD and still has work to do in order to make a move above the secular highs made back at the peak of 2007 housing bubble. In January the index came within 1% of those highs.
While the information technology sector remains near the top of the leaderboard on a year to date basis (+12.41%), the last two months can be categorized as erratic at best. July fared a little better than June but the last 2 weeks of the month have taken its toll. For the month of July the Information Technology sector was up just 2.04%. Within the sector, Software and Services was up +2.15% while Semiconductor and Semi Equipment was +1.60% and Hardware and Equipment was up +2.02%. While June’s bugaboo was geopolitical in nature in the form of a brewing trade war, July’s Achilles heel is good old fashion earnings. Softer than expected earnings releases from technology bellwethers Facebook, Netflix and Twitter opened the markets eyes to the crowded positioning in the Information Technology sector as a whole. Currently the sector accounts for 26% of the S&P 500’s market value, significantly higher than the next largest sector which is Health care at 14%. While July seemed to be rebounding early from a sluggish June, earnings surprises in combination with ongoing growth being called into question has significantly trimmed the sectors strength in the later part of the month. Finally the FANG Index (Facebook, Amazon, Netflix, Alphabet/ Google, Apple, Twitter, Tesla, Nvidia, Alibaba and Baidu), synonymous with the sectors performance over the past few years, dipped its toe into correction territory earlier this week. The index fell 2.8% on July 29th, placing it 10% below its June 20th record for the second time this year.
Despite all indices and sectors registering positive returns in July (save -0.1% for the Russell Microcap Index), it is worth noting a few market relationships which could potentially be flashing early warning signs in terms of sentiment and changes in leadership reflecting a more cautionary environment. For i.e. the ratio of the consumer discretionary index (cyclical) vs. the staples index (defensive) had been in a steep uptrend since breaking out of a two year base in September of 2017. The ratio peaked in early June and has since been consolidating which from one perspective can be seen as healthy pause given the prior steep uptrend, however the corrective pattern has the look of a common topping pattern (H&S) and the ratio has recently broken down below the neckline support.
The ratio of small caps to large caps is important not only because small caps are seen as being riskier and thus when outperforming usually signal a “risk-on” environment, but also because they represent breadth and broad participation. The ratio of the Russell 2000 vs. the SPX peaked in June at the same top it made back in December 2016. Small caps have since been underperforming and have not yet shown signs of stabilizing. Currently 65% of the members within the Russell 2000 are trading above their 200 day moving average which is down from 2018’s high of 72%, and 2017’s high of 80%.
Another perspective on risk sentiment can be viewed by analyzing the performance of high beta stocks vs. low volatility stocks. The ratio of the S&P 500 High beta ETF (SPHB) relative to the S&P 500 Low Volatility ETF (SPLV) made a four year high in June and has since been consolidating lower. While the ratio remains above the YTD lows from early April, it has dipped down below its 40-week moving average (synonymous with the 200-day). Also, the ratio’s momentum indicator (weekly RSI), which can often lead “price”, is making fresh YTD lows.
Earnings – is “really good” good enough?
Heading into Q2 the open question was whether Q1 earnings, which saw growth of over 24.8%, would be the “high water mark” for the year. Put differently, was the best behind us and could the market support valuations if earnings plateaued at a high level? So far, equities have responded well to a very solid Q2 earnings season. According to FactSet's latest Earnings Insight report, the blended earnings growth for Q2 S&P 500 EPS currently stands at 21.3%, which is higher than the 20% that was expected going into the quarter. However, this is below the 24.8% growth seen in Q1, so the solid results may be in the eye of the beholder. Both quarters are the best since Q3 2010 so there is a bullish argument to be made around earnings growth. At the same time, tariff concerns and “peak earnings” summarize the bear case.
In Q2 so far, there have been more earnings “beats” than average. Of the 53% of S&P 500 companies that have reported through 7/27, 83% have beaten consensus EPS expectations, better than the one-year average of 75% and five-year average of 70%. But, if you want to get picky, companies are reporting earnings that are “only” 2.5% above expectations, below the one-year average of +5.6% and the five-year +4.4% average. This seems to suggest that the solid Q2 was mostly as expected (very good but below Q1). The blended revenue growth rate is 9.3%, which would be the highest since Q3 2011 (12.5%).
One element that can’t be ignored is the potential for tariffs by the U.S. and its trading partners to raise costs for businesses and consumers alike, denting earnings. Caterpillar seems to be a great case study for this. In Q1, CAT’s CFO famously said during the company’s earnings call that the quarter would be the “high water mark” for the year. The statement captured the market’s fears and caused a sharp reversal in the stock and the broader market as well that day. In Q2, CAT beat on earnings and raised its earnings outlook due to strength in end markets despite tariff impacts that are expected to be felt in 2H’18. CAT shares sold off on earnings day despite the good results, and analysts lowered price targets and downgraded the stock on fears the company is late in the cycle.
Looking at future quarters, analysts currently project earnings growth to continue at about 20% through the remainder 2018. However, they predict lower growth in the first half of 2019. The forward 12-month P/E ratio is 16.7, which is above the 5-year average and above the 10-year average.
So once again, will corporate earnings be enough to drive valuations or will growth slow and concern over tariffs hurt sentiment?
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