Charts of the Week: Dual Tailwinds – Sectors

Market headwinds are typically pretty visible. We could probably name a bunch off the top of our heads – geopolitical risk, potential for tax changes, some increasing input costs, high earnings expectations, election cycle volatility - to name a few. The problem with each of those variables is that it’s hard to prove (via history) that there’s a consistent impact on market returns. That’s not to say the issues don’t matter – they do. But many times, the market either discounts bad news in advance or another critical variable creates a tailwind that you’re not watching (perhaps because you are too busy focusing on the very visible headwinds). To me, the latter looks to be happening as we speak. Crude and rates are both down over the last year, together by a top decile amount.

This is rare without job loss. And this has been consistently predictive for the market throughout the decades. The bigger the “stimulus” from those joint forces, the more likely the market is to be higher, with returns over the last 25 years averaging almost 20%. Why? Because these factors matter for future earnings growth. Since 1962, earnings also grew an average of 20% the year following moves like this. If you’re highly skeptical of lofty earnings expectations, the consistency of this correlation should give you pause.

The consistent impact doesn’t stop with earnings growth or the economy (ISM shows a similar pattern). The bigger the “stimulus” from rates & oil, the more likely economically sensitive sectors are to outperform the market. The relationship is quite linear, with sectors like Discretionary, Tech & Financials outperforming the market by an average of 3-5% over the following year. On the oppositive side of the ledger, defensive sectors, like Utilities, Health Care & Staples, typically underperform the market by an average of 4-8%. That is a lot of numbers to illustrate the cyclical, pro-risk impulse that typically occurs. Which sectors specifically have the most persistent trends? Real Estate on the positive side. ?

Utilities on the negative side. If this historical analysis is a guide, the recent defensive rotation we’ve seen might not have much staying power. And, if you’re looking for “what’s different this time” in our easing cycle – this is one of the critical datapoints. And it’s bullish.

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