Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
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EQ: The market received favorable news regarding GDP growth for the second quarter earlier this week, as well as a revision of the first quarter’s decline. The markets traded sideways for the most part on Wednesday, almost as if unsure how to react to the news. What are some reasons for the hesitation?
Stovall: I think that was because investors, on the one hand, may be thinking they should increase their exposure to equities since the economy is doing very well. Even though investors were predicting a 3% recovery in Q2, we actually ended up getting something even better than expected. So that was a positive for equities.
Yet, on the flip side, investors may also be thinking that the too-good-to-be-true number could lead to the Fed being more willing to increase interest rates earlier than currently predicted in 2015. I think investors are going through a “yeah, but…” kind of scenario, where the positive is offset by the Fed possibly pulling the punchbowl away a little more quickly.
EQ: The Fed didn’t really say anything in addition to the statement from the press release, correct?
Stovall: The Fed issued a press release and the one thing that I read from it was a fairly dovish comment as it relates to longer-term interest rates. Maybe the concern that investors have is that the Fed may be more willing to raise rates, but I think the Fed is basically saying that based on the data they see and the interpretation of that data, it does not give them cause to accelerate the current timetable.
So I would tend to say that the Fed’s commentary supported the strong economic growth, and the implication was they would not be willing to raise rates more quickly.
EQ: While the U.S. economy seems to be running along steadily, the recent harsher sanctions imposed on Russia could be a concern for potential ripple effects through interconnected global economies. While Russia’s economy will obviously be affected directly, do you see any potential unintended effects on the U.S. markets?
Stovall: Well, I can’t help but think about that reality TV show called When Animals Attack. You push a creature into a corner far enough and if it feels threatened, it will strike back, even if the one doing the pushing is substantially larger.
So, I worry that the European Union and the U.S. may end up going too far and not offering an opportunity for the Russians to save face, because the one thing they do have—their ace in the hole, if you will—is natural gas. I don’t think the Germans are going to start using old cuckoo clocks as fuel for this coming winter.
So, I think that the U.S. and Europeans need to be very careful about how far and how hard they push against Russia.
EQ: In this week’s Sector Watch, you examined the sell in May effect and seasonal rotation strategy on small caps. The Russell 2000 was gaining nicely until July, until it plummeted over 5% this month. Could large caps follow suit?
Stovall: It’s reminding some investors of what happened just before the dot-com bubble burst in early 2000. In 1998, you had the small-cap stocks begin to diverge, the advance decline line start to head lower, and breadth start to wane. So I think investors are a bit concerned because when you have less and less participation in the equity markets, that it is not a good sign.
It’s funny how economists worry about the participation rate when it comes to employment, but some people are just brushing off the lack of participation as it relates to the equity markets. So, I would tend to say that the concern that investors have now, and I would put myself in that camp, is that fewer and fewer stocks participating in this rally could mean that it will probably be coming to an end relatively soon.
EQ: When applying the seasonal rotation strategy for small caps, what has the historical performance been? How has it compared to the performance when applied to the overall market?
Stovall: The historical performance—and this is going back to April 30, 1995, which is as far back as the S&P Small Cap 600 extends—if you were long the broader benchmark S&P Small Cap 600 from November until the end of April, but then were in the S&P Small Cap 600 Consumer Staples and Health Care sectors from May through October, this strategy would’ve added 320 basis points per year to the Small Cap 600’s performance, while producing 10% lower volatility based on annual standard deviation of returns.
Investors can use some ETFs to mimic this. You can look to iShares Core S&P Small-Cap (IJR) for the broader benchmark, and you can then look at the PowerShares S&P SmallCap Consumer Staples ETF (PSCC) , as well as the PowerShares S&P SmallCap Health Care ETF (PSCH) for the defensive sectors. So you can employ this rotational strategy by using these three ETFs.
EQ: How does the small-cap rotation strategy compare to the rotation strategy for the S&P 500 and its defensive sectors?
Stovall: The returns were similar in that, if you applied this technique going back to 1990 for the S&P 500, it showed an outperformance of a little more than 300 basis points per year as well as a reduction in annual volatility.
This technique beat the S&P 500 about 65% of the time, which was actually less than the 79% of the time that this sell in May strategy worked for the Small Cap 600. So performance and volatility was similar to the 500, but the batting average was much better for small caps than large caps.