U.S. economic data is softening and volatility remains low as the third quarter gets underway, but for all the activity among favored tech stocks during the second quarter, U.S. equities could only manage a very small gain. A relative calm that seems to have set in, but one firm is warning that investors should prepare for a massive rotation that may be starting.
A rotation to drastically change the market
Jefferies Chief Global Equity Strategist Sean Darby and team pointed out in a note dated July 3 that the S&P 500 only rose 2.74% during the second quarter. The Jefferies team added that although both the equity market and the economy are undergoing a “disinflationary boom” of sorts, it would be unwise to become complacent at this time because of the rotation they see starting.
In fact, they feel the rotation that’s starting to take place “could sharply alter the character of the market in the second half of this year. They cite several “non-macro factors” that happen to be occurring at the same time as the yield curve’s flattening.
Some market watchers have been surprised at how much the yield curve in the U.S. has flattened, although many blame President Trump's inability to deliver on any of his campaign promises. Others blame the decline in economic surprises paired with temporary peaks in expectations for inflation.
However, the Jefferies team feels that what we're witnessing right now is a twist on the "Greenspan 'conundrum'" that occurred in 2005. They see the mini taper tantrum that occurred last week following commentary from the European Central Bank's president as a warning that the bond market's long side is far more important for stocks than short rates, even though equities are "long duration assets." They also noted that a rotation has already occurred in some areas.
Rotation from Growth to Value?
So where might this rotation the Jefferies team senses be coming from? There are two I will spotlight here, but what they are probably seeing is a much broader rotation affecting much more than these two isolated areas. The first is a rotation from Growth stocks to other factors, and multiple firms have been highlighting it for some time.
In a MarketWatch post, Brett Arends considered whether the sudden decline in Tesla's stock could be a signal for a much broader rotation away from Growth names. He noted that the MSCI index of Growth stocks has outperformed Value stocks by the largest margin over the last 10 years than it has since the late 1990s, so it's no wonder so many market watchers are expecting the bubble to stop soon.
Arends noted that Tesla's "stunning, violent plunge" over the last two days is simply out of proportion to what has been happening. The news this week has merely included a slightly worse-than-expected safety rating for the Model S, Volvo's announcement that it's shifting to an all-electric and hybrid lineup in a couple of years, and little else to warrant its slip into bear market territory.
Instead, he argues that the "dramatic, manic surge" in the stock price over the last couple of months has been akin to "speculative mania with borrowed money," and now "a lot of gamblers rushed to sell at the first hint of trouble." He adds that long durations of Growth stocks outperforming Value is usually reversed for a long duration, and thus, he sees Tesla as a canary in the coal mine signaling a rotation from Growth to Value.
Rotation into foreign equities
Another potential rotation that may occur is a shift from U.S. to foreign equities. In a post for MarketWatch, Jeff Reeves considered whether U.S. investors should look to overseas stock markets, given that U.S. equities have hit a wall. He outlined a few reasons why we may soon see the end of the extreme tear U.S. equities have been on since after the lows in 2009.
One is the uncertainty involving the Federal Reserve, as many investors have been left in a quandary after the last Fed minutes. Although inflation isn't a problem currently, interest rates are rising amid mixed signals from the central bank. Meanwhile, the Fed is retaining the trillions of dollars' worth in government bonds, and wages is a further signal of division at the Fed.
He also feels that the markets are depending too much on an earnings rebound in the Energy sector, and the job market has cooled as volatility is starting to creep back in as the ear index ramps up. So will all these factors result in an equity rotation overseas? Reeves thinks this might be a good time for one, and others are starting a rotation of their own. The Jefferies team highlighted in their note that the U.S. equity market has been underperforming global peers for the last two quarters, giving U.S. investors plenty of reason to look overseas.
