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July 15, 2004
As Stocks Go On The Defensive, Bears Eye Summer Blitzkrieg

Given that the VIX and bear/bull surveys (II) – historically accurate indicators of excessive investor complacency/fear – proved ineffective at predicting a turning point in stocks during last years rally, it is difficult to flush out speculations about investor sentiment trends today.  For that matter, given that mutual fund flows are likely to be seasonally weak/unpredictable going forward (until Sept/Oct), that the US economy is displaying mixed signals, and stocks are stuck in a range, it is difficult to draw decisive conclusions about the near term direction of stocks until something, anything, happens.

These caveats noted, a phrase comes to mind: when all else fails look at what type of stocks investors are buying and selling. 

Recession Stocks Flying Higher (than most) In July

Sometimes leadership changes in the stock markets are important because they comment on the investor’s appetite for risk.  Using yesterday’s action as an example, a negative Intel warning helped pull the major US stock indices lower, but amidst this sell off utilities and energy stocks were pushed higher.  In other words, investor’s changed their risk appetite yesterday: from highly valued tech stocks with tiny dividends to more fairly valued utilities with solid dividends.

Granted, tracking industry performances on a given day will not allow you to predict the direction of the markets tomorrow. Rather, in trying to grasp potential sentiment shifts the study of hot/cold industries is, by itself, only helpful in hindsight.  However, when considering traditional business cycle investment trends, some interesting and more rounded findings can be made.

Industry

July

YTD

Outperform during

Energy

1.91%

14.04%

Late Expansion

Industrials

-1.36%

4.98%

Mid Expansion

Consumer Staples

-0.50%

4.61%

Contractiion/Defensive

Utilities

0.40%

2.20%

Contractiion/Defensive

Financials

-2.07%

-0.89%

Early Expansion

Health Care

-2.32%

-0.92%

Contractiion/Defensive

Consumer Discretionary

-2.69%

-2.16%

Early Expansion

Materials

-1.84%

-2.19%

Mid Expansion

Information Technology

-7.98%

-7.90%

Early Expansion

S&P 500

-2.57%

-0.04%

 


Is it important to note that the industries that have been the strongest as of late are considered to be late cycle or contraction industries? I would venture to say yes.  After all, can anyone seriously argue that a rally in energy and utility stocks – the only two industries up in July - is ushering in another up leg in the bull market?
 
It is not difficult to understand why certain industries perform better/worse during economic contraction/expansion. Rather, mature industries typically grow slower and pay more dividends (these industries are less attractive during expansions) while newer industries typically grow faster and pay less dividends (less attractive when times are tough). For an example of these ideas using retail sales numbers, consider the long-term growth patterns of computers versus beer sales. Growth in computer sales, while clearly stronger, is nonetheless more volatile than growth in alcohol sales.


Most investors would think that the above chart does not paint alcohol related companies in a positive light.  After all, sales for computers are hot, hot, hot, and beer sales are growing at a snails pace by comparison. However, start the growth chart off from 1999 and a completely different comparison is made. 



Point being, tech is cyclical whereas alcohol typically is not.  If investor capital is moving out of tech and into alcohol (and/or other ‘defensive’ stocks) this could mark the beginnings of a sentiment shift.

The Extremes Have Become Less Extreme

During the drunken mania days tech stocks roared while most other industries roared less loudly: Intel versus Diageo PLC (or BFb) aptly demonstrates this trend.

Despite absurd rallies in isolated industries and stocks (nano, bio, i-net, micro), today’s mania is not as crazy as that seen in the late 1990s (i.e. tech is not valued as highly as it was in the 1990s compared to ‘old’ economy stocks). What this implies is that investors have diversified their holdings and/or are less willing to chase performance.

Given that capital is more evenly distributed one would assume that market sell offs would be more evenly distributed. However, this is not the case. Instead, REITs crashed earlier this year, many housing stocks have been mauled, and financial stocks have yo-yoed due to the changing interest rate environment. Point being, it is difficult to find any individual industry that is suffering because money is piling into a select few industries.  This is extremely disappointing news for the value seeker (i.e. there are no dividend safe havens like there was in the late 1990s).

Conclusions

Whether or not Intel’s Chips are a better investment than Brown-Forman’s Jack Daniels is not the question at hand (INTC and BFb are both risky investments when looking at trailing fundamentals). No, the question is why are defensive stocks leading the way as of late, and why are tech and other early cycle stocks floundering?

Earnings warnings and weaker than expected economic reports suggest that early cycle stocks are weak because the US expansion may have already peaked. By contrast, energy stocks are rallying because the up-cycle isn’t over, and utilities are strong/stable because interest rates have stopped rising (making utility yields more attractive).  These are some of the basic speculations to be made. However, the more evenly distributed capital base the marketplace has not embellished these trends, and these trends could reverse quickly.

In short, select industries/stocks are being punished unless perfect earnings/guidance are reported because very little new capital is arriving in the markets.  Moreover, investor’s are on edge because they face many daunting challenges between now and November (i.e. seasonal trends, terrorism, and economic slow down).  Whether or not economic expansion soon reasserts itself or the market’s malaise this year ends up resembling 2000 is uncertain at this time. All that is certain is that recent stock rotation trends suggest that the 2003 mini-bull market is over.

Suffice it to say, for bears the news – the soft economy and late cycle stock market activity - is encouraging. And if this type of news persists until late August/September, don’t expect the bruised bears stand idly by any longer.