In a little while, I will be rolling out a feature that examines the relative performance of various segments of markets as a bottom-up way of understanding and anticipating macro themes that are important to the longer-term trajectories of markets. An example of such bottom-up analysis is reflected in the relative performance of sectors within the stock market.
Is tech leading market performance, while defensive sectors lag? That is one kind of market. Are we seeing outperformance from consumer cyclical companies relative to consumer discretionary ones? That is a different kind of market. All tell us something about economic and growth expectations of market participants. To the extent that markets are forward-looking, such information can be valuable, reflecting the implicit forecasts of many agents.
So what is sector performance telling us right now?
The top chart, from the excellent Finviz site, shows us that sector performance has been highly variable over the past month. Utilities have dramatically outperformed Basic Materials shares and many sectors have gone nowhere over that period, despite the meaningful uptick in market volatility. I would argue that the relative outperformance of Utilities, traditionally viewed as market defensiveness, is nothing of the sort here and now. Rather, the market is pricing in a disinflationary environment, in which rates will be staying low for long. In such an environment, a factor that will drive returns is carry, the yield on any particular asset. With disinflation and low rates, the yield of utility shares is attractive and there is little attraction to inflation-sensitive commodity-related shares.
If this is correct, we should see carry continue to attract capital across asset classes, from currencies and rates to stocks. We've already seen a reach for yield in rates markets, as investors have gone further out in duration and further out on the low-quality spectrum to achieve carry returns. At some point that will end badly, but the market is not telling us that point is now.
The middle chart is my tracking of rolling 20-day correlations among stock market sectors and the bottom chart reflects rolling 20-day volatility among sectors. Typically in a market cycle, volatility and correlation expand into market lows and continue high as the market rebounds. As a cycle matures, volatility wanes and correlations come down, as we see reduced volumes and more divergent day-to-day performance among sectors. One of the things I find interesting now is that sector performance, per the top chart, is divergent, but we're still seeing high day-to-day correlations of sector movement. In other words, sectors are moving in relative lockstep, but some are moving with more strength than others.
The continued high levels of correlation and volatility suggests to me that the current market cycle, coming out of the mid-October lows, is still relatively early in its development. If precedent holds, we should see a momentum peak in breadth, followed by declining volume, volatility, breadth, and correlation, as stocks top out. The resilience of stocks itself reflects a forecast that continued low rates and the recent decline in energy prices will not be negatives for corporate earnings growth.
Further Reading: The Importance of Sector Correlations