Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: In this week’s Sector Watch, you noted that May fizzled a bit in the final days of the month. Could this be setting up a swoon in June and the long-awaited digestion of gains?
Stovall: I think it is setting itself up for the long-expected digestion of gains, but it all depends on how you define “swoon”. A swoon to me is a decline in excess of 5 percent, and our belief is that it will end up being loud noise, which means a decline of 3 to 4-plus percent but probably won’t break that magic threshold to claim that it is a pullback or something deeper. Also, our expectation is that the market will likely close the month of June higher than where it entered.
EQ: You also observed that the defensive sectors of the S&P 1500 dropped considerably. Considering that Telecom dropped 7.2 percent and Utilities falling 8.8 percent in one month, should investors be alarmed that these conservative areas made such a drastic move?
Stovall: They should be alarmed only from the standpoint that if they had purchased these groups when they were trading at such lofty valuations. The P/E on the four defensive sectors—Consumer Staples, Health Care, Telecom, and Utilities—reached a peak of 17.5 while the remaining sectors traded as low as 13.5. So what basically happened was the darlings of the first quarter became the overly expensive holdings of the second quarter and once investors started questioning when the Fed would start to taper off on its bond-buying program, the expectation was that the higher-yielding groups would be the most adversely affected by this switch. As a result, investors started bailing out of these groups.
EQ: The cyclical sectors continue to perform well. Is the sector rotation into this group accelerating?
Stovall: What we’re seeing is that all areas of the market are declining. The defensive sectors are still falling more than the cyclical, but what we’re finding is basically everything is being thrown out with the bathwater. So investors need to determine what their core beliefs are and where they see the economy 12 months from now. Where do they see corporate earnings and which sectors are likely to benefit from that expected direction of the economy and earnings? And how do valuations currently look based on that belief?
Our belief is that the economy will continue to improve over the next 12 months and earnings will continue to inch higher. Therefore, we remain slanted toward the cyclical side of the sector ledger and the defensive groups will likely continue to take a back seat.
EQ: The S&P 500 returned about 11.5 percent for the first six months of the year. Do you like the prospects for the second half to close higher from where we are right now?
Stovall: I do think the market will close higher than where we are now. I think the one thing that will be different in the second half that was missing in the first half is volatility. In 2011, the S&P 500 experienced 21 days in which it declined by 2 percent or more in a single day. The average since 2000 was 15 such declines per year. Yet in 2012, we only experienced three such days. So for us to get back to normal, we would have to experience five times the volatility that we experienced last year. Similarly, we’re seeing a very small number of days—I think we only had one down day of 2 percent or more thus far in 2013. So with the market taking it on the chin the way it did on June 5, I would tend to say expect an increase in volatility to go along with the likely higher prices by the end of the year.