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MID Special Update: Q4 Review and Current Equity Market Themes .

The December and Q4 Review and Look Ahead from Nasdaq’s Market Intelligence Desk (MID).

MID Special Update: Q4 Review and Current Equity Market Themes

Q4 Market Performance Table:

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Summary:

  • The Dow finished 2016 with seven consecutive weeks in the green, which ties the all-time record.
  • The small cap focused Russell 2000 gained 19.5% for 2016, the best performance since 2013 and the biggest outperformance vs. the S&P 500 in six years.
  • Sector rotation was a huge driver in the fourth quarter as the leaders and laggards throughout the first half of 2016 reversed roles in the second half, particularly so in Q4.
  • Financials were by far the top performing sector in Q4 gaining 20.5%, and they finished 2016 up 20.1%. Energy was steadier throughout 2016 and finished the year as the leading sector with a 23.7% gain.
  • Healthcare was the only sector with declines for the year, falling 4.4%.
  • The U.S. Dollar gained 15.4% versus the Japanese Yen during Q4, marking the second largest gain in 45 years.

U.S. stocks proved to be resilient this year, as U.S. equity prices were able to shake off precipitous declines in January and June. Q4 opened with a range-bound pattern for the major indices implying investors were on the sidelines ahead of the U.S. election and expected Fed rate hike. Mid-quarter, the election results kicked off a sharp rally and significant sector rotation. The S&P 500 advanced for the fifth consecutive quarter, while the Russell 2000 spent the second half of 2016 catching up to larger cap names and finished higher by more than 19% YoY.

The Dow Jones Industrial Average (DJIA) posted its best quarterly performance in three years with a gain of 7.9% in Q416. The blue chip index peaked at 19,987 on 12/20, less than 20 trading days after it first reached the 19,000 milestone on 11/22.

Technically Speaking

With all eyes then set on the psychologically important 20,000 level, the DJIA failed to reach this newest milestone as it was already exhibiting extreme “overbought” technicals. Its daily relative strength index (RSI) peaked on 12/13 at 87.4, measuring the second highest reading in 61 years. A bearish divergence then emerged when price peaked on 12/20 as the RSI was already making lower highs, indicating the index was entering a longer period of consolidation. The index finished 2016 with seven consecutive weeks in the green, which ties the all-time record. The Dow has never been up for eight consecutive weeks. So while a greater period of consolidation may be in the cards, the bigger picture price action is constructive.

Below we highlight some of the main themes in sector performance.

4Q Sector Performance:

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Note: Chart cell colors indicate out/underperformance within a given quarter.

Healthcare stocks were the weakest this past year as biotechnology companies pulled the sector lower. The Nasdaq Biotechnology Index fell 20.7% in 2016 while a surge in Crude Oil (+20.5%) prices helped the S&P Energy Index rally to its best year since 2007.

The election results fueled a sector rotation theme that carried out throughout Q4. Small Cap and Financials lagged the broader markets for the first 10 months of year, but as political initiatives were unveiled, a clear money shift began.

Q4 sector performance was a one-horse race with Financials far outperforming the 10 other S&P sectors. The S&P 500 Financials Index gained 20.5% in Q4 with the Energy and Industrial sectors coming in a distant second and third, each with gains of 6.6%. This outperformance was triggered by the unexpected election results as markets priced in an era of deregulation, tax reform and increased fiscal spending.

Fueling the outperformance in financials was the sharp increase in rates where the UST 10-year yield gained 85bps for its second strongest quarterly gain since 1Q’94, surpassed only by Q2’09 when markets were first coming out of the Great Depression. While some pundits believe financials have run too far too fast, the last time the S&P Financials sector experienced a quarterly gain of more than 20% was in Q1’12. It then went on to post quarterly gains in nine of the following ten quarters. Financial stocks are also expected to benefit from a reversal of headwinds from post-housing crisis regulations, low growth and the Fed’s zero interest rate policy (ZIRP).

On the topic of ZIRP, the Federal Reserve increased rates 25bps in December for just the second time since first going to the zero bound in December 2008. It now expects three more rate hikes in 2017, up from its own prior expectation of two.

Amid expected policy changes and signs of accelerating U.S. economic growth it was small-caps that demonstrated the sharpest increases, outperforming large cap stocks by over 5% in the Q4. After underperforming large-caps since 2013, small-caps trounced the rest of the market in 2016, especially since the election, on the notion that the Trump administration will focus on domestic policies and the expectation that large caps would likely be hit harder if trade issues were to emerge or the U.S. dollar continues to strengthen. The Russell 2000 gained 8.43% in Q4 and 19.5% for the year, more than double the Q4 and 2016 gains of the S&P 500, which added 3.3% and 9.5%.

Energy – Crude oil had its best returns in several years with WTI gaining 45% last year and Brent up 52%. The much discussed OPEC production deal gets much of the credit and investors will see how that plays out over in the coming months. Natural Gas bested crude in 2016 with a nearly 60% gain, although forecast of warmer weather has natgas starting the year with an 8% drop. Energy stocks that were left for dead last year saw sharp gains as crude price firmed and the outlook for the commodity stabilized.

Semiconductors – stood out as the best subsector in the Technology space with the Philly Semi Index (SOX) closing out 2016 with its ninth consecutive Q4 advance. This past year was very strong for chip stocks as the SOX gained 37%, outpacing the rest of the technology sector (S&P Info Tech Index +12%) by its largest gap since 2003.

Consumer Discretionary – Consumer Discretionary stocks posted positive returns for the quarter, but sold off in late December to temper gains. The holiday season is an important period for major retailers, generating a disproportionate level of sales and profit contribution. Holiday 2016 spend topped $1 trillion, beating 2015 by about 3.8%. S&P Retail Select Industry Index saw a return of 1.2% for Q4’16 and 1.9% for the year while the large cap S&P 500 Consumer Discretionary sub-index rose 1.9% for the quarter and 4.3% for the year.

4Q Sector performance graph:

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M&A

M&A was a theme during the Q4 with more than $1.4 trillion in global deals (proposed and pending), and bringing the 2016 total to $3 trillion. Some of the largest North American deals include AT&T for Time Warner ($107B), British American Tobacco for Reynolds American ($58B), and Sunoco Logistics for Energy Transfers ($51B). October was the largest month for global M&A in at least 12 years.


LOOKING AHEAD:

Earnings Preview:

The earnings recession came to an end in Q3 when growth turned positive after five consecutive quarters of declines. The growth pace is expected to continue in Q4 and ramp up in the following quarters. For Q4’16, the estimated earnings growth rate for the S&P 500 is 3.2%. If the index reports earnings growth for Q4, it will mark the first time the index has seen year-over-year growth in earnings for two consecutive quarters since Q4‘14 and Q1’15. For Q4’16, 77 S&P 500 companies have issued negative EPS guidance and 34 S&P 500 companies have issued positive EPS guidance.

Almanac:

Seasonally January has been a very difficult month for the S&P 500. Over the last 5, 10 and 20 years, the SPX has average returns of (0.47%), (1.70%) and (0.50%). All three time periods fall in the bottom quartile of the 12 calendar months ranking 11, 12 and 10. The last three Januarys in 2014, 2015, and 2016 declined—3.6%, 3.1% and 5.1%—only the third time since 1950 the S&P 500 has experienced three consecutive Januarys in the red. While all of this paints “doom and gloom” for the start of 2017, there are reasons to believe January 2017 could buck the trend. First, the S&P 500 has never declined four Januarys in a row and the current environment of animal spirits in the market place makes it difficult to believe this time will be different. Also, January is one of the most volatile months of the year. So while the average returns over the last 5, 10, and 20 years are all in the red, when positive, the S&P actually does quite well in January. Over the last 20 years, the S&P 500 has been in the green 50% of the time, and, when positive, has an impressive average gain of 3.12%.

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Small-cap stocks tend to outperform large caps in January. This is commonly referred to as the “January Effect”. This seasonal pattern is clearly revealed by the graph below, which shows over 36 years of daily data compressed into a single year for the Small-Cap Russell 2000 relative to the Larger-Cap Russell 1000 index. When the graph is falling, large caps are outperforming smaller companies; when the graph is ascending; smaller companies are outpacing large caps. The seasonal strength of Small-Caps tends to last through June, although we see the majority of the move made by early March.

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Figure 1 Source: stocktradersalmanac.com

Potential Leadership:

The financial and healthcare sectors stand out as potential leadership candidates in 2017, for contrasting reasons. 2016 was a tale of two stories for the financial sector. At the midpoint of the year, financials were the worst performing sector with the S&P 500 Financials Index declining (4.15%) through 1H’16. As equities rallied following the Brexit selloff and rates rebounded from generational lows, financials were the top performing sector in 2H’16 with a gain of 25.3%, including a 20.5% gain in Q4. For comparison the next two top performing sectors in 2H’16 were technology and industrials with gains of 13.3% and 10.4%, while in Q4 the next best performer was energy with a 6.6% gain. The last time financials gained more than 20% in a quarter was in Q1’12. The sector then went on to post gains in nine of the next ten quarters with average quarterly returns of 4.3%. Thus from a momentum point of view financials appear to be best positioned to continue their outperformance.

As a mean reversion candidate, the healthcare sector stands to rebound from a difficult 2016 where the S&P healthcare index lost (4.4%). The group was weighed down by the biotech industry with the Nasdaq Biotech Index declining (21.7%) in 2016 and (40%) from its 2015 highs. Coming out of the prior financial crisis, healthcare and particularly biotechs were one of the top performing groups from 2009 through mid-2015 and were arguably due for a period of underperformance. Having peaked in mid-2015, it has been a long 18 months of corrective price action. If the bull market is going to continue in 2017, last year’s dog could be this year’s darling.

China:

China remains a wildcard as we enter 2017, not unlike this time last year. Capital flight, concerns of abrupt policy shifts, slowing growth rates, and rising consumer costs all combine for a potentially volatile mix. Capital outflows in the neighborhood of $200b are expected in Q4 with the research department at Natixis speculating outflows likely reached as much as $833 billion in 2016 through November, about 12% more than in all of 2015. Currency outflows could lead to additional devaluations of the yuan, leading to yet more outflows in a negative feedback loop. It’s estimated that China has about $3.05 trillion in currency reserves, enough to prove a buffer in case of a crisis according to the IMF.

The yuan dropped about 7% against the dollar in 2016, and that is nearly double the 2015 rate. Recall it was a surprise devaluation of the Yuan that set of a crisis of sorts in equities in January 2016. Recently, however, the Yuan has strengthened as it appears authorities may be supporting the currency.

China’s Shanghai Composite was one of the worst performing major indexes, losing 4.5% last month and down over 12% for the year as trade volumes fell by over 50%. High levels of debt in China are a potential destabilizing force, but growth in that country, while slowing, is still expected to be better than that of many western economies. The OECD expects GDP growth to slow to 6.1% by 2018. U.S. GDP is expected to be about 2.4% over the same period.

None of the above addresses the possibility of increased tariffs on goods to and from China, which would almost certainly be perceived as a negative outcome.

Europe:

The continent bears watching as elections in the Netherlands, France, Italy and Germany during 2017 will pit incumbent parties against nationalist and potentially anti-Euro parties. Much would have to happen of course, but the headline risk to the market is a win by a party large enough, in a country large enough, to cause concern about the Euro. The underlying and still unsolved issue of high sovereign debt among member countries also remains.


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.

Brian Joyce, CMT has 16 years of trading desk experience. Prior to joining Nasdaq Brian executed equity orders and provided trading ideas to institutional clients. He also contributed technical analysis to a fundamental research offering. Brian focuses on helping Nasdaq’s Financial, Healthcare and Airline companies among others understand the trading in their stock. Brian is a Chartered Market Technician.

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