Mr. Market is Scared About The Economy This Year

On May 24, 2016

“Wall Street discounts the future,” wrote Charles Dow, the founder of the Wall Street Journal in 1899.  Dow biographer Paul Shread said, “Dow’s observation [was] that the stock market is the ultimate leading indicator, alerting investors to deterioration and improvement in economic conditions before they ever show up in government reports and statistics.”  If this is true, what does Mr. Market see for the rest of 2016?

One way to analyze the market’s movement is looking at the broad averages.  A listing of such measures below does not give much direction for the balance of the year.

Average 2016 Year to Date as of 4/30
Dow Jones Industrial Average +2.00%
Standard & Poor’s 500 +1.05%
NASDAQ Composite -4.63%
Russell 1000 (Large Cap) +1.05%
Russell 2000 (Mid and Small Cap) -0.44%

A more precise way to spot trends is to look at sector results.  The chart below presents the year to date measure of the 10 Dow Jones sectors from top to bottom.

Sector 2016 Year to Date as of 4/30
Utilities +12.24%
Oil & Gas +11.95%
Telecommunications +10.76%
Basic Materials +  9.80%
Industrials +  5.61%
Consumer Goods +  3.27%
Consumer Services –   0.24%
Financials –   1.81%
Health Care –   3.68%
Technology –   4.37%

Examining the bottom groups first, Technology has become a capital goods sector.  It is cyclical in phase with broader economic growth trends.  It indicates that the business investment slump seen in the first quarter GDP numbers are likely to continue.

Health Care’s decline has a capital spending component (Biotechnology has the worst results for the industries in the group) and a consumer component (Pharmaceuticals is the second worst group performer), that both foresee weakness ahead.  On the other hand, the group has also been impacted by non-economic forces this year (Valeant and the demise of tax inversions.)

Another pro-cyclical group, Financials, have had weak results.  Real Estate Services, Investment Services and Mortgage Finance, all indicators for the economy, led the decline in this sector.

On the positive side, Utilities has staged a major comeback after a long period of underperformance.  Although it has seen favor from investors looking for current income in the low-interest rate environment, Utilities has not been a top group until the past 12 months.  As would be expected, the group crushed the market in the recent correction.  Surprisingly, it has held up well in the rebound (it has been the best sector in the three out of the last six weeks.)  When Utilities outperform, it means the market is not sanguine about the economic road ahead.

Why would Oil & Gas be so positive given weak first quarter earnings and lower energy prices than a year ago?  The market seems to be attracted to its real asset status.  If economic growth looks sluggish, it may be a better course of action to hold onto to a historically cheap tangible asset.  By the way, two of the top Basic Industry groups are Gold Mining and Platinum & Precious Mining.  This is consistent with the strength of the energy industries.

Finally, Telecommunications has outperformed for similar reasons as utility stocks foreshadow slow economic growth ahead.

This analysis clearly indicates that the stock market sees economic trouble ahead.  The safe havens of high yielding stocks and tangible assets have outperformed more economic sensitive sectors.  The economic community has minimized the importance of the weak 0.5% annualized first quarter real GDP growth number released late last month since second quarter GDP has rebounded smartly during the past few years.  We feel that the revised first quarter numbers will be lower when released in May and June since March retail sales, housing and industrial production were not better than January’s and February’s figures.  As more of March’s activity gets reflected in GDP, growth will decline closer to 0.0%.

Second quarter expectations, currently in the 2.0% to 2.5% range, will decline when it becomes clear that the first quarter weakness has spilled over to the current one.  Also, the Commerce Department, which computes GDP, has made significant adjustments to reflect recent changes in quarterly economic activity.  It is likely that there will be little second quarter rebound due to mis-measurement during the first quarter in future years.

Recommendations:  The iSectors® quantitative model expects this trend to continue.  If it is correct, the Federal Reserve will not raise interest rates this year.  Thus, there will be continued demand for safe haven assets including:

  • Long-term Treasury bond funds such as the iShares 20+ Year Treasury Bond ETF (TLT) and the ProShares Ultra 20+ Year Treasury ETF (UBT)
  • Utility funds such as the iShares U.S. Utilities ETF (IDU)
  • Tangible asset funds such as the Vanguard REIT ETF (VNQ), Market Vectors Gold Miners ETF (GDX) and Sprott Physical Gold Trust (PHYS)

iSectors Implementation: For financial advisors, the easiest way for their clients to be optimally exposed to expected market trends is to invest them in the iSectors Post-MPT Growth or iSectors Post-MPT Moderate Allocations.  The asset allocations in these strategies are based on a sophisticated statistical and computational model that aims to minimize downside risk by investing in low or moderately correlated sectors.  Currently, these Allocations have overweights in Treasury bonds, Utilities and tangible asset sectors.

For advisors that wish to add 10% to 20% of client portfolios into tangible asset sectors, the iSectors Inflation Protection and the iSectors Precious Metals Allocations should be considered.  Although past performance may not be indicative future returns, these Allocations had the best results of all 14 iSectors strategies in the first quarter.  Both of these strategies own funds that have the best tax treatment available and do not issue K-1 tax forms.

Individuals who wish to be referred to advisors utilizing iSectors Allocations should call Chuck Self at 920-257-5168 or email [email protected].

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