Sunday, October 09, 2016

Investors Rotating Out Of Income Generating Equities

Since mid August the S&P 500 Index was down approximately 3% to mid September, but has recovered about 1.3% to Friday's close. The market seems to be having difficulty finding direction, trading mostly sideways since mid July, as can be seen in the below chart that includes the transport index as well.

As I noted in a post in early September, transports began outperforming the S&P 500 Index at that time after trailing the broader market for most of the second quarter. When the transports begin to lag the broader market there is some belief this is potentially a precursor to a weakening economy that leads to a decline in the S&P 500 Index. As the above chart shows though, transports appear to be in decent shape, potentially pulling the S&P 500 up with it on improving economic fundamentals.

A part of what seems to be occurring in the broader market is a rotation out of the income and defensive sectors. In looking at sector returns since the beginning of the year (blue bars) and returns since the end of June (yellow bars), the weakest part of the market since the end of the second quarter has been health care, staples, REITs and utilities. The top performing sectors since June are the more economically sensitive ones, technology, financials, energy and industrials. I have discussed in earlier posts about the likelihood of the coming end of the earnings recession in Q3. Aggregate 'as reported earnings' for the S&P have already increased for three consecutive quarters.

This rotation out of the defensive/income sectors is also showing up in the downtrend in the advance decline lines for the defensive/income sectors.

A part of the flow out of dividend yielding stocks is the anticipation of a Fed rate hike before year-end. The 10-year Treasury yield has already moved higher from a yield of 1.32% in July to 1.73% at Friday's close. Higher interest rates tend to result in the price of dividend yielding stocks, bond like equities as some call them in this low rate environment, to fall. This has been the case with the bottom performing income oriented sectors. The price decline has been relatively quick as can be seen in the below chart of the utility sector.

In conclusion, the S&P 500 Index remains just 1.7% off its August high in spite of quite a bit of pessimism. The AAII bullish sentiment remains at a low level, 28.79%, and fund flows continue to exit equities with funds suffering their worst weekly out flows of the year, yet the market remains near a high. From a technical perspective, Charles Kirk of The Kirk Report always cuts through the noise to provide good technical detail on the markets and stocks. In his report this week he provided the below chart noting:
"Overall, the probabilities still favor a bullish breakout to higher highs. Why is that? The combination of both the short and long-term bullish plays that remain in motion. The longer-term double bottom breakout play targeting S&P 2365 remains in play. While price has seemingly stalled out over the past seven weeks, there has not been any significant roll back either other than the -3% throwback retest last month that successfully tested and held support. All that is needed now is to take out the August highs and start acquiring the numerous bullish target objectives."

All else being equal, I believe the earnings recession should end this quarter (energy is a wild card and key) and the sideways market action is partly due to sector rotation. As more certainty is established about the election outcome and the Fed rate decision, equities could see a move higher into year end.

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