As Sam Sees It: Why Stocks Are Climbing the “Wall of Worry”

Sam Stovall  |

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: Up markets come in different forms, and in this week’s Sector Watch report, you noted that the market’s upward movement has been led by higher-yielding defensive sectors. What does this tell us about this recent rally?

Stovall: Since the June 1st low through Friday Aug. 3, while the S&P 500 was up close to 9 percent, three of the five best-performing sectors were from your traditional defensive categories. The Telecom Services group was up close to 12 percent, Healthcare was up almost 9 percent, and Consumer Staples was up a bit more than 8 percent. Also, another group that many don’t necessarily regard as defensive, but historically has been the fourth best-performing sector during market declines since World War II, is Energy. This group was up more than 13.5 percent. The only true cyclical outperformer was Financials, which was up more than 10 percent.

In addition, what was interesting was that four of the five sectors sported dividend yields equal to or greater than that of the S&P 500. Telecom Services has a yield of 4.5 percent, Healthcare with 2.3 percent, Consumer Staples with 2.8 percent, and Energy at 2.3 percent. The only one that had a lower yield than the market was Financials. Over this total move higher, the indication that I get is that investors were using the recent market decline as an opportunity to load up on the defensive, higher-yielding sectors. What’s also interesting, however, is that we are seeing some investors begin to nibble at some of the cyclical sectors.

I look at rolling 52-week relative strength charts—meaning, how the sector has performed over the last year divided by how the market has performed over the last year—and that frequently gives me a longer-term glance as to what new trends are being developed by the markets overall. I’m starting to see a rotation that began in the mid-to-late part of July toward the more cyclical areas, in particular the Industrials category at the expense of the defensive areas like Telecom and Utilities.

So what this tells me about the recent rally is that because we are seeing gravitation most recently toward some of the traditionally cyclical sectors, this implies that this rally still has legs because investors believe we might end up seeing the market move higher for an extended period. So rather than selling out of the defensive groups and going into cash, they’re actually selling out of the defensive groups and moving into the more cyclical areas.

EQ: Investors that have been on the sidelines may have missed the rally off the June low and could be waiting for a pullback before getting back into the market. Could they potentially miss out on additional gains before that pullback occurs?

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Stovall: Yes, I think that’s a possibility. Usually when the market rises in the face of pessimism, investors are left on the sidelines scratching their heads. As a result, you then have little by little, investors capitulating and throwing in the towel, which therefore continues to push share prices higher, thereby climbing a wall of worry. Right now, that wall is very high and it’s very slippery because I would say the bear argument is a much more logical, much more coherent argument than the bullish case. But as we all know, investors are always looking down the road anywhere from six to 12 months. Our belief is that investors a year from now are likely to be looking at economic and earnings trajectory that are upwardly slopping, rather than the current downwardly slopping trends in both areas of growth. That said, I don’t think that investors should mortgage the ranch or go on margin in order to purchase stocks. I think that if they do have an allocation that is appropriate for their risk tolerance and time horizon, use this as a reason to stick with it rather than trying to sell into this strength. Our belief is that right now we have a 12-month target of 1500 for the S&P 500, based on projected earnings of about $107 for the S&P 500 and expectation that we could see a slight P/E expansion to 14 times.

EQ: Given the amount of uncertainty regarding so many global economic developments in play right now, the market could experience a major swing in either direction depending on how things play out. Are defensive sectors still a good position for investors who want to be exposed to the market's potential upside and limit their downside risk?

Stovall: Yes, there’s an old saying that a rising tide lifts all boats, and so you’re better off being in a defensive sector than you are being in cash, in my opinion. Just realize that defensive sectors are likely to earn less than the cyclical sectors, but still do better than cash. I have also been mentioning to investors recently that another strategy they might want to consider is looking at the low volatility subsets of the broader benchmarks. By that I mean, for the S&P 500, the low volatility subset consists of the 100 stocks in the S&P 500 with the lowest trailing 12-month standard deviation. This subset has done exceptionally well, posting a compound rate of growth of 6.6 percent in each of the last five years through the end of July, versus 1.1 percent for the S&P 500. It also has had substantially less volatility, declining 21 percent in 2008 versus 37 percent for the S&P 500.

There are also low volatility components of the S&P/TSX Composite, the S&P Developed International index, as well as the S&P Emerging Markets index. So if you prefer to ride the merry-go-round versus the roller coaster, but you still want to enjoy the amusement park, my belief is you stick with low volatility, rather than just staying cash.

EQ: Despite the, at times, overwhelmingly negative sentiment regarding economic growth and stability, the market actually has a few historical trends on its side to suggest it can keep going higher. Can you talk about a few of these?

Stovall: Certainly for the negative, you have a wide variety of concerns, whether it’s debt related to Greece, Italy, and Spain; worries about how deep the European recession will get; the degree of slowdown in China; the Fiscal Cliff here in the U.S.; the slowing earnings growth expectations; or a treasury yield hovering around 1.5 percent. There are an awful lot of bearish situations that investors can point to and say that’s the reason why they’re staying on the sidelines.

Yet, what’s interesting is this year we saw a positive move for the S&P 500 in both January and February, and historically that has led to an average full-year total return of 24 percent since 1945, with the market rising in 25 of 25 years. Of course, past performance is no guarantee of future results.

Also, the near 10-percent pullback that we experienced from early April through early June took abnormally long, taking more than 40 days to cross that 5-percent decline threshold versus the more normal 19 days. What I’ve also found is that dragged out declines have usually been relatively shallow, and take about two-and-a-half months or so to get back to break-even. This points to a recovery beyond the April high of 1420 on the S&P 500 some time in the latter part of this month. Also, I’ve mentioned in the past that during election years since 1900, 78 percent of election year lows occurred in the first half. Meanwhile 85 percent of annual highs happened in the second half, with a full 70 percent occurring in the fourth quarter, probably once after the presidential uncertainty has been lifted.

Lastly, if you’re surprised that the market is doing well in August, don’t be. August saw the highest monthly average price change since 1900, with the results of September through December also averaging in the plus column.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:


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