Another day, another new high in the S&P 500, initially pulled by growth relative to value. Mid-day news of a bipartisan agreement on infrastructure was enough to help transportation and deep cyclicals catch up to their growth brethren. Biden announced a $1.2T package, which includes $579B in new spending, agreed upon by 21 Senators broken down to 11 Republicans, 10 Democrats and 1 Independent. There is still much work to be done, but any bipartisan bill here means reconciliation can be used for the American Families Plan. All of which points to higher Government spending. However, Biden’s suggestion that this infrastructure bill must proceed with another reconciliation package being tied to it is already causing Republican Senators to backtrack. This isn’t over by any stretch.
Even with yesterday’s late value/cyclical bounce higher, the Nasdaq is now up 10% since inflation reports in May skyrocketed, while the Dow Jones (with much more cyclical and industrial exposure) is only fractionally higher. Last week’s Fed-induced volatility is all but forgotten, with stocks gaining and yields holding their lower trading ranges on the long-end. For now, it seems like the Federal Reserve has threaded the needle with respect to stocks and bonds, although this points to a shift in direction of leaders under the surface. There are underlying historical factors to consider as well.
One of the oldest technical indicators still alive today is Dow Theory. Although this is not widely used anymore, it does offer some common-sense reactions to markets. In simple terms, a market is in an uptrend if both the Dow Jones Industrial and Dow Jones Transportation averages are breaking out to new highs together. A downside reversal is struck when one of the averages fails to follow through and then makes successively lower lows. This divergence points to caution.
It makes intuitive sense as well, and usually happens when the Dow Jones Transportation average breaks down first. Transport companies shift goods from sellers to buyers. If they are expected to ship less product in the future, then demand is obviously peaking and stocks will decline. When they break down, something is amiss. Since the Dow Jones is a broader index covering many sectors, it could hold up longer than a railroad or trucking company, but transportation businesses are solid leading indicators. Here are the past few months in graphic form:
As you can see, transportation stocks are well off their highs, while other indices are posting new records. History is not on our side here. There have been 47 such sell signals over the past 120 years. During the following few months, the Dow Jones usually suffers.
However, and here’s the positive caveat, since the financial crisis and subsequent changes to the index, this indicator has become much less of an overall negative. General Electric#, ExxonMobil, Raytheon, Alcoa, and General Motors are no longer in the 30-stock average. They have been replaced by the likes of Salesforce#, Walgreens, Apple#, United Health# and Cisco#. This old index is not tied to just manufacturing goods anymore. When seeing reports of another Dow Theory sell signal, take it with a grain of salt. Indicator usefulness comes and goes. This may point to some individual sector or stock weakness, but is hardly a call to sell everything like decades past.
All of which points us right back to what is now working, namely technology, predictable growth and self-help stories. That is a distinct change from late last year when vaccines were introduced. Banks, commodities, heavy machinery and “junk” stocks were huge winners post-November. Now that inflation and GDP are peaking, gains from here will gradually revert back to a more normalized market environment. Those highly cyclical sectors will still have winners, but not at this incredible speed or breadth. Upcoming data will help parse out those that can continue leading from here.
Earnings season is upon us in a few weeks. Everyone knows that the year-over-year comparisons will be the easiest on record. Guidance is likely to be solid as well. Pent-up demand is real, but the market has already priced in reopening winners. What should we expect for June of 2022? Who wins when unemployment checks end, stimulus fades, tapering starts and the Fed dot plots get closer to a reality?
Market cycles often rhyme. Lower-quality companies which were crushed during the recession rebound faster and stronger than more diversified high-quality ones. Early cycle stock prices already reflect that. Phase II, or mid cycle, is clearly coming, if not already here. This is the longest phase in a typical business rotation, and is one characterized by moderate growth, where an economy gathers momentum and monetary conditions remain accommodative, but not excessive. Higher-quality stocks start to take over, relative to low quality. Historically, technology, communication services and disruptors (in any sector) which are taking market share also resume leadership roles.
Today, quality stocks, on a relative basis, are extremely inexpensive:
Work doesn’t end there. While a rising tide can lift all boats initially, winners during mid-cycle phases start to shine brighter. Not all high-quality companies will win. I would define quality as companies with pricing power, leadership in their product lines, clean balance sheets, wide moats and the ability to grow earnings throughout the business cycle.
As always, take another look at your portfolios. Focus on those stocks which lagged recently. Can they win in the next portion of this economic phase? Would a less accommodative monetary and fiscal policy hurt their prospects? Is valuation appropriate in a slower growth world going forward? Summer is upon us but much work needs to be done!
The Office star, Angela Kinsey turns 50 today while Ricky Gervais is now 60. “You’re So Vain” artist Carly Simon turns 76 today.