A fellow trader suggested to me yesterday that the outperformance of the defensive sectors was no sign for concern for the broader market. He said that he only becomes concerned about defensive outperformance when they are flat to slightly up, while the rest of the sectors are mostly lower. In the current case, he said, the defensives are outperforming, but only because they’re up very strongly, while everything else is only up modestly. To him, that’s simply because the market sees good future prospects for these sectors going forward, and naturally, that’s a positive sign, not a negative sign.
It’s an interesting proposition. The new growth leaders are staples and health care, catering to a changing demographic and economic landscape. But I don’t buy it.
First, here’s the chart of consensus expected S&P 500
(INDEXSP:.INX) earnings growth over the few years:
SPX Annual Consensus Earnings, Courtesy of Bloomberg
In short, the market is expecting about 10% earnings growth for SPX components, which would be healthy growth that would sustain further stock market gains. And therein lies the problem with defensive sectors leading. Defensive sectors outperformance is a worrying sign since they don’t offer much earnings growth. Cyclical leaders of a bull market typically have growth rates in the 15-25% range. Meanwhile, companies like Colgate-Palmolive
(NYSE:KO), Procter & Gamble
(NYSE:PG), and so forth have not grown earnings more than 10% over the last two years and are not projected to do so in the next two. So it’s hard to see major appreciation if earnings are only growing 5-10% in the leading sectors of the stock market.
Now in the short term, the SPX could move another 50 points higher just for the heck of it (psychology drives the short term). But for the long-term fundamental underpinnings of the current market, it would be much healthier to see better earnings growth and guidance from the cyclical sectors, and rotation similar to today, when staples and health care are lower. But the market is willing to rotate in cyclicals.
This item by Enis Taner was originally published on RiskReversal.com
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