- The S&P 600 and the Russell 2000 are falling behind the rest of the stock market.
- Cyclical stocks were a great investment in the economic recovery, but some sectors are losing steam.
- The economist who called the housing bubble thinks these are signs the market rally is stalling.
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It’s easy to see why investors have been so optimistic lately. Thanks to a terrible first quarter during the early days of the pandemic, stocks across the board are poised to report exceptional year-over-year earnings. First-quarter earnings announcements from the big banks this week backed that theory up, as Morgan Stanley, Goldman Sachs, and others crushed analyst expectations.
Meanwhile, the broader economic recovery seems to be proceeding apace. Retail sales rose 9.8% in March according to the latest Census bureau data, while weekly jobless claims hit their lowest levels since the beginning of the pandemic.
With report after report of positive news powering the S&P 500 to new highs this week, it’s no wonder that investors widely believe the good times will keep rolling.
There’s just one problem: investors are wrong.
At least that’s what David Rosenberg, the chief economist & strategist at Rosenberg Research, believes. Rosenberg is famous for his predictions about a housing bubble in the mid-2000s that turned out to be spot on. While many dismissed his bearish outlook at the time, Rosenberg saw the signs of a growing problem and caught on before the rest of the market.
Now, Rosenberg is seeing one signal that makes him wonder if this rally can really last. That signal is the disconnect between the broader stock market and small caps.
In a recent research report, Rosenberg notes that since March 12 the S&P 600, an index of small cap stocks, has declined 5%, while the S&P 500 has risen 5%. This divergence is a worrying sign, particularly when coupled with the fact that it isn’t restricted to just one sector — in fact, every sector within the S&P 600 is trailing its equivalent in the S&P 500, says Rosenberg.
Rosenberg notes that cyclical sectors such as energy, materials, financials, and consumer discretionary have dropped particularly hard since March 12, while utilities, technology, and real estate have done better. The poor performance of the cyclical sectors leads him to believe that “broad-based cyclical exposure is no longer warranted at this point in the recovery.”
The combination of small caps lagging the market and cyclical sectors taking a turn for the worse is a warning sign for Rosenberg. “This tells us that small cap underperformance has been broad-based which, in combination with the aforementioned weakness in cyclical sectors, is a pretty decisive risk-off signal beneath the surface even as the S&P 500 continues to make all-time highs,” Rosenberg writes.
Rosenberg isn’t the only analyst worried about the divergence between the S&P 500 and small caps. In a recent note to clients, Morgan Stanley’s chief US equity strategist Mike Wilson wrote about his concerns regarding the growing divide between the S&P 500 and the Russell 2000, which has underperformed the former by 8% since March 12.
And just like Rosenberg, Wilson is worried about the decline in cyclical stocks’ performance. “Furthermore, some of the cyclical parts of the equity market we have been recommending for over a year are starting to underperform, while defensives are doing a bit better,” writes Wilson.
He continues: “In my view, the breakdown of small caps and cyclicals is a potential early warning sign that the actual reopening of the economy will be more difficult than dreaming about it.”
Wilson goes on to describe the problems these stocks will face in the coming months, including a supply shortage in “everything from materials and logistical support to labor” due to lockdowns. The result is that even if companies report the strong earnings that everyone expects thanks to easy year-over-year comparisons, their future forecasts for costs and margins may paint a grimmer picture than anyone anticipates.
As small caps stall out, 2 sectors still look strong
“Massive amounts of stimulus, positive results on the vaccine front, and the re-opening of the economy” have fueled the pro-cyclical trade, Rosenberg notes, but the market has shifted away from broad-based cyclical exposure. With a broad-strokes approach to investing in the reopening no longer viable, where should investors turn?
Valuations in energy and financials remain supportive, Rosenberg writes. “While broad-based economically sensitive exposure has worked well, we believe the easy money has been made and investors will need to become more discerning in terms of allocations. To us, this means sticking to Energy and Financials as the best way to play this trade going forward.”
Investors looking to gain exposure to energy stocks can consider the iShares US Energy ETF, which tracks domestic producers and distributors of oil and gas. Meanwhile, an investment in the iShares US Financials gives investors exposure to US banks, insurers, and credit card companies.
The market’s rally has been predicated on reopening trades powered by small-cap and cyclical stocks. But with small caps and the broader market parting ways, and cyclical stocks starting to lose steam, investors should prepare their portfolios for a bumpy road ahead.
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