The Game is Changing
April 1, 2014
I recently wrote a post on monitoring whether we're in a stock picker's market and the importance of volatility and correlation to tracking error. Monitoring the market's economic sensitivity is also important. Generally speaking, the stock market can be broken down into four areas of economic sensitivity:
- Defensive stocks: Stocks that perform well when investors become especially concerned about the economy. These tend to be in the consumer staples, health care, telecommunications, and utilities sectors.
- Late-stage cyclical stocks: Stocks that perform well after the economy has been growing strongly for several years and decelerating. These tend to be in the consumer staples, energy, materials, telecommunications, and utilities sectors.
- Early-stage cyclical stocks: Stocks that perform well when the economy is starting to accelerate. These tend to be in the consumer discretionary, financials, industrials, and technology sectors.
- Secular growth stocks: Stocks that perform the best when the economy is growing at a steady pace but neither accelerating nor decelerating. These tend to be in the consumer discretionary and technology sectors.
With all of the economic data coming into the market every day, it should be easy to identify the winners and losers, right? However, it's actually more complicated than it seems because these groups of stocks tend to react more to investors' perceptions of what the economy will do than they do to the actual statistics that are reported. So day-to-day, investor sentiment can have a significant impact on the relative performance of these groups. And sometimes, one group can dominate or lag for several months or longer.
For example, from 2009 through the first quarter of 2010, early-stage cyclical stocks led the market with secular growth stocks a close second. However, as economic expectations began to decline in mid-2010, secular growth took the lead. This lasted through third quarter of 2012, when economic expectations began to stabilize and early cyclicals started to show renewed vigor. As 2013 unfolded and investors began to realize that expectations had stabilized but weren't rapidly accelerating, defensives led the market with early cyclicals remaining close behind.
This past summer everything changed! The Fed announced the possibility (yes, just a possibility!) of tapering asset purchases in upcoming months. Investors paused because not only did they have to consider the market's economic expectations but also the Fed's reactions to changing economic data. When would tapering start? How much each month? What about the discount rate? Would the Fed change that also? And just how dovish is Janet Yellen? For years, investors didn't need to think about these types of issues as the Fed was on auto-pilot, flooding the market with liquidity.
Secular growth stocks and early cyclicals jumped. But then economic expectations declined and the Fed decided to hold off on tapering … secular growth took the lead. As 2013 closed, economic expectations increased somewhat amid the start of Fed tapering and the beginning of the Yellen era. Secular growth and early cyclicals have been back and forth ever since.
First, growth led and more recently, it was early cyclical—despite no significant change in economic expectations. And while dispersion did recently decline due to the situation in Ukraine, it is still greater than it was for much of 2013. The waters are tough to navigate.
Historical Stock Performance and Economic Sensitivity
Past performance is no guarantee of future results.
Sources: Morgan Stanley, Bloomberg LP
So now what? Well, in her first FOMC meeting as chair, Janet Yellen was as clear as could be. The Fed could start raising rates in as soon as six months. What? Huh? Sometimes someone makes a statement that is literally so clear, but still unexpected, that it is completely unclear. Both growth AND early cyclicals declined as defensives came to the forefront and investors also took shelter in long-maturity U.S. Treasury bonds.
So now investors are confused and Fed officials are trying to backtrack. And as always, we at Calamos are watching economic expectations and listening closely to Fed speak. We're entering a period where bad economic news may be perceived as good since it could mean that the Fed will hold off on raising rates. (For more on this, see Gary Black's recent post.)That's likely to be good for early cyclicals. If economic expectations don't change much and the Fed is successful at calming rate hike fears, it is likely to be good for secular growth.
How do we use this information? Not only do we monitor which of the above types of stocks are performing the best, but we also monitor our exposure to these types. We seek to ensure that the exposures are aligned with our top-down views and the specific mandates of various portfolios. For example, our growth strategies are managed to be more heavily weighted in secular growth and early cyclicals over defensives whereas our value strategies favor early and late cyclicals over growth. Our growth and income and market neutral strategies tend to have exposure to all of these types of stocks.
The information in this report should not be considered a recommendation to purchase or sell any particular security. The views and strategies described may not be suitable for all investors.
The price of equity securities may rise or fall because of changes in the broad market or changes in a company's financial condition, sometimes rapidly or unpredictably. Equity securities are subject to "stock market risk" meaning that stock prices in general (or in particular, the prices of the types of securities in which a fund invests) may decline over short or extended periods of time.
Correlation is a measure of how two investments move in relation to each other. Dispersion describes the size of the range of values for a variable.