Heavy is the Head
On six previous occasions going back to the 1930s, the S&P 500 gained more than 14% in the second quarter and followed it with a positive third quarter. Each time the index rose again in Q4. The average gain was 9%, from a low of 2.44% in 1997 to a high of 15.88% in 1935. Six years is a very small sample, however, and the strength of today’s all-time highs is hiding a weaker picture underneath.
Growth over inflation
The Atlanta Fed’s GDPNow model is tracking third-quarter growth at 3.7%, up from 2.2% in Q2, signaling an accelerating economy. When paired with sticky inflation, the strong economic backdrop has historically favored cyclical areas of the market, with Energy usually taking the lead as the strongest performer. Since energy companies benefit directly from higher oil, natural gas, and refined product prices, inflation is passed through to earnings, as it did for them from 2004 to 2007 and again in the 2021-2022 reflation cycle. Energy Select Sector SPDR (XLE) was up 15.8% last quarter.
Pave’s models picked up a growth-oriented picture last Friday. Energy was the highest-scoring U.S. large-cap sector with more than four in every five names scoring positive. Consensus behind the energy sector fund itself was thin, however, pointing to a level of persistent uncertainty sitting among investors. Quality funds are carrying some strong consensus though, and are joined by broad large-cap growth funds in the top 5% rank of Pave’s universe. Defensive sectors are sitting near the bottom of the rankings, with consumer staples and utility funds in the bottom third.
The view on inflation is a little trickier to read. TIPS improved last week but only in step with nominal Treasuries, suggesting investors are not paying up for inflation protection. T-bill funds fell from the top third of Pave’s fund rankings to the bottom fifth, intermediate bonds improved, and long-dated Treasuries stayed near the bottom of the rankings. Gold slipped just slightly and oil was roughly unchanged in Pave’s rankings, and for a second straight week the signal in Pave’s models came from growth. September CPI is due next Wednesday, October 14, and should show whether inflation is keeping pace.
Financials names and funds diverge
Financials are historically a winner in a rising rate and growth environment, but simply owning an index is a poor expression of this. Pave’s models suggest the weakness sits at the fund level, since a substantial number of individual names scored positive from Friday’s readings. Financial sector funds—bank, broker, and insurance-focused funds—scored below zero last week.
At the stock level, more than 80% of U.S. large- and mid-cap banks scored positive, with some of the strongest consensus of any industry in Pave’s universe. Life and health insurers, property and casualty insurers, and brokers also scored well as individual names. Investment banks were a main weak spot in Pave’s universe.
The rates backdrop appears to be moving in banks’ favor in the near term following last Friday’s weaker-than-expected September jobs report, which pulled the odds of an October rate hike from 70% to 24% (CNBC).
The steeper yield curve, with the 10-year/2-year spread bouncing up from 0.20 on September 21 to roughly 0.48 today, supports bank margins, though credit losses remain a risk to watch (FRED). Today’s 3-year note auction cleared slightly below the pre-sale yield, even though the bid-to-cover ratio came in slightly below the recent 10-auction average (Morningstar). The mixed demand might be just that, or a signal that inflation really is easing. Watch demand levels in the 10-year and 30-year auctions on Wednesday, October 7 and Thursday, October 8 for a gauge on inflation concerns.
A narrow market under a strong index
Today’s all-time highs strike as a cause for concern toward an overly concentrated market. Breadth is near its lows for the year, as the index’s top decile masks deterioration across the broader market. The three-month correlation between the S&P 500 and its equal-weight version is 0.63, compared to an average of 0.93 since 2011, and it fell below 0.60 in September, the lowest reading in the series (Flux Markets). Pave’s models ranked the S&P 500 in the 95th percentile (top 5%) of funds last Friday, while its equal-weight version ranked in the 66th percentile.
Away from the top-decile names in the S&P 500, Bloomberg points out that 29% of stocks in the index have a negative market beta (Christopher Cain, Bloomberg). This is the highest share since at least 1995 and well above the historical median of 1.6% (Cain). 90% of individual stock variance is idiosyncratic, a 99th percentile reading, and the average S&P 500 constituent’s volatility is 34.6%, compared with 12.3% for the index itself (Cain). At its peak, Goldman Sachs measured the same metric reaching 45% of the index (three-month rolling basis) (CNBC).
Though a high share of negative beta is rare, the number of negative names tends to surge when market leadership becomes extremely narrow. The current environment resembles periods like 1999 to 2000 in one respect, namely that index returns are being driven by a relatively small group of mega-cap winners. The rest of the constituents are moving independently or even in the opposite direction.
The share of U.S. stocks scoring positive in Pave’s rankings fell steadily with company size, with fewer than two in five micro caps making the cut. Top scorers included growth and quality funds, with high rankings and strong consensus behind them. Software and semiconductor funds scored high as well but covariance readings in Pave’s models indicated a lack of investor certainty.
It is worth weighing the positive seasonal record and strong index against how few stocks are doing the work. Looking at inflationary measures in the coming weeks will hopefully reveal a clearer picture on where things are headed.
By Stephen Evans, CFA
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