The Wrong Sectors Are Leading the Market Higher

Source: Thinkstock

Source: Thinkstock

The S&P 500 has risen about 6 percent this year, and many investors would believe that is because stocks are a “leading indicator” that this portends well for the future of the economy in spite of recent negative economic news. However, a closer look at the components of the S&P 500 reveals that this belief may well be fallacious. The trouble is that the wrong sectors are leading the market higher. If we look at the top performing sectors for the year, we find that these are not sectors that we want to be leading the market higher if we want to see the economy improve. The following sectors are outperforming the S&P 500.

The leader for the year is the utilities, which are up 15 percent. Utilities are rarely growth stocks, and they are typically a pillar of stability in a portfolio. They generate stable, recurring revenues and they tend to pay out a sizable portion of their earnings to shareholders in the form of dividends. In short, they aren’t unlike bonds. Given these attributes, investors favor them over other stocks when they are looking for safety rather than growth and momentum. The fact that utilities are leading the market higher suggests that there are few growth opportunities, and that the economy is stalling out.

The second best performing sector this year is energy. On the one hand, you might think that this is a good thing. If energy stocks are rising then there is presumably demand for energy, and this demand comes from economic activity. But another catalyst, such as the one that is driving the market so far this year, is rising energy prices. Oil and gas prices have had strong first halves, and while this is great for energy companies it is lousy for the rest of the economy. The energy that businesses and consumers need is rising in price, and this eats into their profits and spending power.

The third best performer is healthcare. Healthcare is very similar to utilities in that investors flock to healthcare stocks when they want stability and dividends. While there are, of course, some growth stocks in the sector, these are small compared to your giants such as Johnson & Johnson (NYSE:JNJ) and Pfizer (NYSE:PFE), and they contribute very little to the performance of the sector. The strength in these stocks, therefore, is driven by a defensive mindset, and investors should consider this outperformance to be a warning sign that growth is slowing.

The last sector that is outperforming the S&P 500 is the materials sector. This sector is very similar to energy. On the one hand, you might think that the outperformance of basic materials stocks means that there is demand for these materials. But in fact it is largely being driven by strength in the commodity markets, and this is driving up the profits of these companies at the expense of the rest of the economy.

Now, if we move on to look at the underperforming sectors, we see that these sectors are economically sensitive and their profits can diminish if commodity prices are rising. Of the underperforming sectors only one — consumer staples — is considered to be defensive. The rest are all economically sensitive. For instance, the two worst performers are retail and consumer discretionary, which are sectors that outperform in a strong economy. These are the only sectors that are actually down for the year. Other sectors that are up, but which are underperforming are technology, financials, and industrials. These, too, are economically sensitive sectors, and their underperformance indicates to me that investors are largely bailing out of economically sensitive stocks and moving into defensive stocks.

Unless this trend reverses, investors need to be extremely cautious. That isn’t to say that the market is setting up for a major correction in the next few days or weeks, but I think it is coming. We have already seen the first step towards a decline which is the outperformance of defensive stocks and commodity stocks. The next phase will be a market roll-over. When we begin to see signs that this is happening, it is time to take profits in stocks and put your money in cash or in only the highest quality defensive stocks. Pretty much everything else will be vulnerable to the downside.

Disclosure: Ben Kramer-Miller has no position in any of the stocks mentioned in this article.

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