Early-cycle stock sectors are the key to whether economic recovery becomes full-blown economic expansion. This, in my opinion, should be investors’ number one issue right now. The data are increasingly showing that the economy is indeed recovering, so investors must now decide whether this nascent recovery can actually become expansion.
Lower quality stocks are handily outperforming higher quality ones as they should during a recovery, and as was forecasted by the earlier outperformance of lower quality bonds. In 1991, subsequent to the 1989/90 banking debacle, stocks ranked C&D by Standard & Poors (i.e., the lowest quality stocks) rose 91%. So far this year, they are up 82%, according to Merrill Lynch research. Higher beta and low price investments around the world have similarly been performing well, and it seems bullish that the consensus continues to focus on “quality” despite these stocks’ outperformances.
When one looks at sector performance, the data are considerably more inconsistent, and it is this inconsistency upon which equity investors must focus. Consumer discretionary stocks are indeed performing well, but so are late-cycle commodity-related stocks. Since the end of March, S&P 500 Consumer Discretionary sector has risen 17.7% versus 15.5% for the Materials sector. However, the Materials sector outpaced Consumer Discretionary 12.3% versus 9.2% during July. An important performance tug-of-war seems imminent.
I have argued for more than a year that weekly initial jobless claims is the most important economic statistic for equity investors. There are three reasons why these data are vital. First, they are weekly data and don’t have a significant lag. Second, employment is critical to this economic expansion given the poor state of household balance sheets. Future credit calamity seems inevitable unless employment improves. Third, weekly initial jobless claims are an official leading indicator of the economy. It is widely thought that employment data are lagging indicators, but broad statements to that effect are untrue. In fact, two of the 10 official leading indicators of the US economy are employment related.
Weekly initial jobless claims have been starting to improve and if that trend continues, it would be a very good sign for the continued outperformance of Consumer Discretionary stocks. Historically, there is a very significant inverse relationship between jobless claims and the performance of the S&P 500 Consumer Discretionary sector. Consumer Discretionary stocks tend to appreciate when jobless claims fall, and vice versa because people are simply more likely to purchase discretionary items when they have jobs.
The outperformance of late-cycle commodity-related stocks, however, is disconcerting. Rising commodity prices act as a tax on the corporate and household sectors. Recent optimism regarding corporate profits is based on cost cutting and productivity, yet rising commodity prices imply increased margin pressures. Employment growth certainly seems unlikely if profit margins remain squeezed. The household sector’s income has barely improved let alone improved enough to negate the tax increase effect associated with rising commodity prices. If the US consumer had trouble with rising gasoline prices when employment was robust, then they are surely going to have trouble with rising commodity prices when employment is still weak.
The global economy is just recovering, and is not yet strong enough to withstand late-cycle pressures. Investors should, therefore, worry that the outperformance of commodity-related stocks indicates that the stock market could be forecasting an extremely short cycle. Indeed, if one is bullish on commodities, then one may be implicitly making the bet that this economic cycle will be extremely short.
One can, of course, make the argument that the BRIC countries (Brazil, Russia, India, and China) have an insatiable demand for raw materials that is supporting commodity-related investments. However, one must keep in mind that the US consumer economy alone is still about three times the size of the entire Chinese economy. The cyclical aspects to global growth are, therefore, likely to be more dependent on the US consumer than on BRIC infrastructure spending.
A tug-of-war between early- and late-cycle sectors may be at hand. If the early-cycle stocks outperform, then the odds are this economic cycle will fully expand and mature. However, if late-cycle stocks outperform, then the odds are this cycle will be considerably shorter than investors currently expect.
Most important, history suggests that lower quality investments will continue to outperform if employment continues to improve and the cycle expands. It may be time to swap Wal-Mart for near-bankrupt retailers.
Richard Bernstein is CEO of Richard Bernstein Capital Management LLC. He was previously Merrill Lynch’s Chief Investment Strategist and Head of the Investment Strategy Group. He has written two books on investing: Navigate The Noise: Investing In The New Age Of Media And Hype and Style Investing: Unique Insight Into Equity Management.
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