Wednesday, June 1, 2016
The Nasdaq Market Intelligence Desk (MID) special report which reviews May's activity and takes a look ahead.
The shape of U.S. equity market indices YTD looks like the classic “square root” symbol. A “V” shaped move in the 1Q gave way to a flat performance in April and May. Market watchers in the 2Q so far have seen a fairly tight range of 2050 – 2100 range for the S&P, which corresponds to roughly 17,500 – 18,000 on the Dow. Underneath what appears to be stable broader averages, there are sector cross currents as leadership changes. Below we will concentrate on these sector moves and review the major drivers for stock performance. The chief market variables – China, oil, Fed speculation, corporate earnings and the U.S. Dollar – are linked to one another, making the levers of market performance unstable at times.
The equity market has taken comfort as oil and other commodities have stabilized in price. China interventions in its currency and equity markets have also reduced the number of red flags for investors to ponder. The dollar weakened throughout much of April, calming fears of a negative impact on Emerging Market economies and the earnings of U.S. companies. However, dollar strength in May bears watching. Despite a third consecutive quarter of negative S&P earnings comps, earnings season was largely as expected. U.S. economic data has generally supported recent market stabilization. A June/July rate hike is now being credibly discussed. The market seems to be taking this in stride, even rallying on more hawkish headlines in contrast to recent times when expected hikes were tabled by the Fed due to equity market uncertainty.
Crude oil closed the month of May with a 6.5% gain in WTI and 3.3% for Brent, the fourth consecutive month advance for both and the longest streak since late 2010. Sentiment was weak early in the month with prices off 5% in just the first two sessions. Frustration over a fruitless OPEC meeting in Doha and soft economic data from China and UK kept prices in check. But by mid-month, unexpected production outages began showing up in weekly inventory estimates; Department of Energy data shows that crude inventories declined in May, the first monthly decline since December. Wildfires in western Canada, civil unrest in Nigeria, and an export blockage in Libya were among the recent supply disruptions supporting prices. By month’s end both WTI and Brent crude were holding just under the $50 level. OPEC is scheduled for a June 2nd meeting in Vienna, but analyst expectations for a production cut are low. With prices stronger of late there is little incentive for change, a sentiment perhaps best expressed by United Arab Emirates’ Oil Minister tweeting recently he is “happy with oil market."
China’s stabilizing its currency market after a somewhat disastrous attempt in January to both weaken the Yuan and allow stock markets to move more freely has provided a measure of comfort to the broader market. Given that the country has served as the growth engine of the global economy, hints of weakness there is a large concern—but this receded from headlines in May.
Will they or won’t they? First it was expected there would be four rate increases in 2016. Then after 1Q turmoil, the expectation moved to either one or no rate hikes this year. With the improvements in sentiment in May, it could now be two. The Fed has a dual mandate of U.S. price stability and full employment. Events have shown us that the FOMC also needs to be mindful of currency effects and its impact on global economies.
Focusing here at home, the stabilizing market and better U.S. economic data have given the Fed room to possibly conduct a June or July rate hike, a step towards a more normal rate posture. Wage cost inflation, the housing market, employment and the retail consumer – though some spending has moved to online purchases at the expense of big box retailers— are potential reasons to increase rates. The Fed must balance this data with the reality that its actions impact the value of the dollar, and hence emerging markets and China – not a trivial concern. Also, rates are negative in many parts of Europe, which helps keep them low in the U.S. Treasuries here compete favorably for investment dollars with German or Japanese debt with comparable maturities, keeping rates low. The Fed has most influence on the short end of the yield curve, which is now the flattest since 2007. Spreads between 2- and 10-year Treasuries are below 1%.
As noted above, Fed rate increases generally support the value of the dollar. Currency markets discount these well in advance. The dollar rallied sharply in 2014 and less so in 2015 on a “divergence” trade that anticipated a stronger dollar and weaker Yen and Euro due to QE policies in those countries. With the reduced probability of 2016 rate hikes, the dollar weakened earlier this year but has been rising again lately. This all gets very circular and is part of the Fed’s quandary: A stronger U.S. economy supports higher rates, which contribute to a stronger dollar. This in turn can have a destabilizing impact on emerging markets and China and also weaken U.S. companies’ export markets and converted foreign earnings, which then can weaken the U.S. economy. The Fed does not want to set off another round of global economic weakness.
This was the third consecutive quarter of declining S&P 500 earnings but the bar was set low enough going into the quarter, that there was not a downside surprise. In fact, “beat rates” were better than expected. Based on about 90% of the S&P 500 having reported through “earnings season” ended in mid-May, 71% have beat consensus EPS expectations, down from recent weeks, but still ahead of the 69% average over the last four quarters. In addition, 53% have beat consensus sales expectations, better than the 50% average over the last year.
If there was a surprise it was maybe that revenues were "less worse" than some had feared, likely helped by a weakening dollar. For the market to move meaningfully higher, earnings will need to improve, but in May they did not drag down the market while other economic data was good enough for the Fed to be entertaining talk of a June/July rate hike.
Value vs. Growth:
Value stocks in the Russell 1000 Index have gained 4.2% in 2016, compared with 1.1% for growth and 2.6% for the S&P 500. The outperformance is a blip in the long-term trend, where growth is ahead by more than 30 points since the bull market began in March 2009. The defensive nature and higher relative dividends of value stocks have helped them outperform at the expense of more “risky” growth stocks this year. However, growth stocks outperformed in May, 1.8% to 1.2%, indicating a greater appetite for risk.
Small Cap vs. Large Cap
YTD, large caps as measured by the S&P 500 have outperformed Small Caps (Russell 2000) by 93 basis points, with a price increase of 2.59% for large caps vs. 1.66% for smaller stocks. This trend reversed in May, with the S&P 500 up 1.5% while the Russell 2000 rose 2.1%. Investors may have been feeling more comfortable hunting for bargains among smaller stocks. The Russell MicroCap index is still down for the year (-1.6%) and the Nasdaq Composite, hurt somewhat by Biotech exposure, is down 1.2%. The NBI index, while significantly off earlier lows, has lost 17.4% so far YTD.
The relatively flat performance of the broader market averages masked significant sector rotation occurring below the surface in May. The table below shows how each sector has performed monthly and YTD. Utilities and Telecom with their high dividends have outperformed in this year’s market environment. Note the turnaround in Energy and IT in May with Energy losing ground after two straight months of strong gains. IT led all sectors in May after being one of the weaker sectors in April. One example of a change in sentiment this year: Materials are up 7.5% YTD after losing 10.6% in January.
Barron's had a feature article that suggested five reasons that even as stocks are approaching old highs, there is room to move higher before any “crash.” These were: high dividend payouts, no housing bubble, a normal yield curve, no “spike” in oil prices and rising new-home sales.
Items to watch for in June include U.S. economic data, the “Brexit” vote, the Fed policy decision, and any clarity or lack thereof around some of the market damaging proposals floated during the presidential election. Spanish elections and an OPEC meeting may also introduce uncertainty. June 24 will also be the date of the Russell Reconstitution, always a significant market-wide event. Despite a VIX that remains below 15, options traders seem to be pricing in higher volatility for June.
The information contained herein is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security or an overall investment strategy. All information contained herein is obtained by Nasdaq from sources believed by Nasdaq to be accurate and reliable. However, all information is provided “as is” without warranty of any kind. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.
Nasdaq's Market Intelligence Desk (MID) Team includes:
Michael Sokoll, CFA is a Senior Managing Director on the Market Intelligence Desk (MID) at Nasdaq with over 25 years of equity market experience. In this role, he manages a team of professionals responsible for providing NASDAQ-listed companies with real-time trading analysis and objective market information.
Jeffrey LaRocque is a Director on the Market Intelligence Desk (MID) at Nasdaq, covering U.S. equities with over 10 years of experience having learned market structure while working on institutional trading desks and as a stock surveillance analyst. Jeff's diverse professional knowledge includes IPOs, Technical Analysis and Options Trading.
Steven Brown is a Managing Director on the Market Intelligence Desk (MID) at Nasdaq with over twenty years of experience in equities. With a focus on client retention he currently covers the Financial, Energy and Media sectors.
Christopher Dearborn is a Managing Director on the Market Intelligence Desk (MID) at Nasdaq. Chris has over two decades of equity market experience including floor and screen based trading, corporate access, IPOs and asset allocation. Chris is responsible for providing timely, accurate and objective market and trading-related information to Nasdaq-listed companies.
Annie O'Callaghan is Director on the Market Intelligence Desk (MID) at Nasdaq. Annie has worked for NASDAQ in a variety of roles including support of Nasdaq C-level management in client retention and customer service. Annie also served as a Sales Director in Nasdaq’s Transactions Services business. Prior to joining Nasdaq, Annie worked at AX Trading, managing accounts for its Alternative Trading System and served on Credit Suisse's trading desk as an Electronic & Algorithmic Sales Trading Analyst.