The recent underperformance of the cyclical sectors that have driven the post-financial crisis rally could be “a sign of trouble ahead for the index”, according to consultancy Capital Economics.
Last week, the S&P 500 surpassed the previous bull-run record set between 1990 and 2000 after going 3,453 days without a 20 per cent correction.
The current rally has benefited from the accommodative monetary policy since the onset of the global financial crisis – including cuts in central bank interest rates and unprecedented quantitative easing – as well as a strong economic recovery.
As such, the S&P 500 has delivered a total return of 372.52 per cent from 3 March 2009 to 22 August 2018 – in US dollar terms – compared with a gain of 259.72 per cent for the MSCI AC World index, as the below chart shows.
Performance of indices since 3 March 2009
Source: FE Analytics
However, leadership of the index has come from a narrow group of stocks known as the FAANGs – Facebook, Amazon, Apple, Netflix, and Google parent Alphabet – making it more sensitive to any downturn in sentiment to this well-hyped group.
Oliver Jones, markets economist at Capital Economics, said: “The S&P 500’s rise for most of the period since the financial crisis – including much of 2018 – has been fuelled by the outperformance of shares in cyclical sectors, which have benefitted most from the health of the US economy.”
However, the cyclical consumer discretionary and IT sectors that have dominated returns for much of the bull run have started to tail off more recently.
“We think that this could be a sign of trouble ahead for the index,” he warned.
Indeed, since early June, the S&P 500 has been driven by stronger performance of more defensive sectors such as utilities, consumer staples and healthcare.
“One possible explanation is that they are less vulnerable to concerns about trade, which have rattled equity markets elsewhere in the world since president Donald Trump approved tariffs on $50bn of Chinese goods in June,” Jones explained.
“Admittedly, they underperformed for several years in the mid-2000s while the S&P 500 surged. And any classification of sectors as cyclical or defensive is arbitrary.
“However, the fact that cyclical sectors did worse than their defensive counterparts as the S&P 500 rose in the run-up to both the dotcom crash and the global financial crisis is not exactly encouraging.”
Performance of sectors in US dollar over 3mths
Source: FE Analytics
John Higgins, Capital Economics’ chief markets economist, said that while he isn’t expecting the S&P 500 to give up its gains immediately as it did when the previous record bull run ended at the turn of the millennium, he does believe it will come to an end next year.
“A key reason why the US stock market is likely to come a cropper between now and the end of 2019 is faltering corporate profits given the outlook for sales and margins,” he explained.
While the sales rose at a double-digit annual rate in the second quarter, Higgins said this was more likely to reflect an upturn in the economy.
He added: “Even if sales slow as we expect, profits could still grow sharply if firms are able to boost their margins. But this also seems improbable.”
Another reason why US stocks may stop advancing is due to slower growth abroad, where S&P 500 companies record more than 40 per cent of their sales. Higgins said that even if as expected, sales from foreign-based S&P subsidiaries slow on trade-war fears, profits could still grow sharply if firms are able to boost their margins. However, he added “this also seems improbable”.
The economist said that while he expects the bull run to come to an end in 2019, he isn’t expecting the S&P 500 to give up its gains immediately as was seen when the dotcom bubble burst. In the three years following the end of that bull run, on 24 March 2000, the S&P 500 recorded a loss of 41.71 per cent, as the below chart shows.
Performance of index in 3yrs after 1990-2000 bull run
Source: FE Analytics
Yet the removal of one-off fiscal stimuli – such as Donald Trump’s tax reforms – and tightening monetary policy – as exemplified by the Federal Reserve’s rate hikes – are likely to make it a tougher operating environment for US companies.
Jones said in such an environment – and given the consultancy’s bearish outlook for the US economy – cyclical sectors that have previously led the rally are likely to perform “relatively poorly” in the months ahead.
“We forecast that US GDP growth will slow sharply next year, as Fed tightening starts to bite and the recent fiscal boost fades,” said Jones. “And in this event, we doubt that the relative resilience of equities in defensive sectors will continue to keep the US stock market as a whole from falling either.”
As such, Capital Economics has stuck to its forecast that the S&P 500 will end 2019 at 2,300, down from levels of around 2,900 currently.