As can be seen in the table below, year to date through May 28, 2004, the classic defensive sectors -- consumer staples, energy, and health care -- offered leadership, while the economically sensitive technology, materials, and telecommunication-services dragged their feet. Weakness in these groups left the S&P Composite 1500 with its head barely above water.
What was behind this sector rotation? In our view, it was the result of investor concern that a rising interest rate environment, exacerbated by unrest in the Mideast and rising oil prices, would ultimately throw the U.S. economy off its growth path and hasten the arrival of the next recession.
S&P 1500 Sector May % Chg.YTD 2003
Consumer Discretionary 0.4 0.5 37.0
Consumer Staples (1.2) 5.3 10.0
Energy (0.4) 6.8 22.1
Financials 1.9 1.1 28.3
Health Care (0.2) 2.5 16.0
Industrials 2.2 1.2 29.9
Information Technology 5.1 (2.5) 47.2
Materials 2.1 (3.9) 33.5
Telecommunication Services (3.9) (0.5) 3.5
Utilities 0.5 0.3 21.2
S&P Composite 1500 1.3 1.1 27.4
S&P 500 1.2 0.8 26.4
S&P 400 2.0 3.2 34.0
S&P 600 1.4 3.9 37.5
NOT-SO-NEGATIVE FACTORS.The price performances in May could be telling us a different story. Even though it's too early to determine if the sector performances in the past month were merely because traders took advantage of oversold conditions in a still-vulnerable market, we think the strength exhibited by the industrials, information technology, and materials sectors could be a sign that investors believe the market is preparing for a modest rally over the coming months.
How do we come to that conclusion? First, let's take a look at the factors that should have driven the market substantially lower -- but didn't:
Increased unrest in Iraq, prior to the June 30 handover of control
The expected beginning of a multi rate-tightening period
Oil prices rising above $40 per barrel
Concern that China's economy may overheat
A serious challenge to President George W. Bush's reelection efforts, and
A projected deceleration of corporate-earnings growth
Despite a very high "wall of worry," it seems to us that the S&P 500 has held up quite well, experiencing a pullback of less than 6% from this year's high. S&P's chief technical analyst, Mark Arbeter, a chartered market technician, recently wrote that the S&P 500 broke out of its very narrow trading range on May 25, indicating to us that the recent pullback was finally over. NYSE price and volume-breadth statistics were strong, showing broad participation by many stocks -- a sign that institutions are finally coming back into the market.
SLOWER RATE HIKES. What's more, we believe the U.S. is still aiming to turn over control to the Iraqi government on June 30, if only to save face. In addition, while we don't see oil prices falling very much during the important driving season, we also don't expect oil prices to rise substantially from current levels (barring, of course, unanticipated supply disruptions).
More important, however, investors are beginning to feel that even though the Fed will likely raise the fed funds rates by a total of 300 basis points (3 percentage points) -- as it did in 1994-95 -- to 4%, Greenspan & Co. will probably take its time getting there. The rate hikes are expected to take place over 24 months, unlike the 1994-95 period, in which the Fed raised rates 300 basis points in 13 months and during which time the S&P 500 advanced 1.2%.
That's why we believe S&P 500 earnings -- which S&P analysts still think will rise 19% in 2004 and 11% in 2005 -- will not likely be dented by the prospect of higher rates. Indeed, the tightening could keep the economy from becoming overstimulated. As a result, the first rate hike may well be greeted by a market advance, rather than a decline.
HISTORY'S GUIDE. Another reason we believe the market may experience a midyear rally can be seen in the chart above. Average quarterly performances for the S&P 500 since 1945 show strength during the first and fourth quarters -- and growing weakness during the second and third quarters.
During Presidential election years, however, the quarterly performances have been upended. The first quarter exhibited a touch of timidity, possibly due to the uncertainty surrounding the selection of Presidential candidates. The second quarter may have benefited from this unwinding of uncertainty, which carried over into the third quarter and was further buoyed by convention promises. But like a teenager who borrowed against future allowances, the market then posted subpar performances once the campaign and election came to a close.
While there's no guarantee that history will repeat itself in this election year, it at least offers an additional reason to believe that things could heat up this summer on the U.S. stock exchanges.
Industry Momentum List Update
For regular readers of the Sector Watch column, here's this week's list of the 11 industries in the S&P Super 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of May 28, 2004.
S&P STARS* Rank
Casinos & Gaming/Consumer Discretionary
Catalog Retail/Consumer Discretionary
Insight Enterprises (NSIT
Consumer Electronics/Consumer Discretionary
Harman International (HAR
Diversified Metals & Mining/Materials
Peabody Energy (BTU
Fertilizers & Ag. Chem./Materials
Home Ent. Software/Info. Tech.
Electronic Arts (ERTS
Internet Retail/Consumer Discretionary
Internet Software & Services/Info. Tech.
Oil & Gas Refining/Mktg./Energy
Technology Distributors/Info. Tech.
Wireless Telecom Svcs./Telecom Svcs.
Nextel Communications (NXTL
* S&P's stock appreciation ranking system for the coming 6- to 12-month period: 5 STARS (buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell). Stovall is chief investment strategist for Standard & Poor's