One of the more surprising aspects of 2020 has been how Technology has disrupted classic early cycle investment patterns. OK, this is not the usual definition of “disruption” that we use in this section but humor us for a minute.
As things stand at today’s all-time high S&P 500 close, here are the returns from March 23rd for large cap Tech versus 2 classic cyclical groups:
- Tech: +63%
- Industrials: +57%
- Financials: +39%
And lest you think the gap between Tech and Industrials looks pretty close, just remember that year-to-date the former is up 26% but the latter is still down 6% (and Financials are down 20%). Nothing about these returns screams “cyclical market”, even though we are clearly exiting a classic, if dramatic, economic downturn. Yes, Tech is the “work from home” trade, but you’d think garden-variety cyclicals would be able to hang in better.
So why do we keep seeing headlines and hearing trading desk chatter about “cyclical rotations” into sectors like Industrials and Financials if their overall return profiles are worse than Tech? Three points on this:
#1: There have actually been 3 micro-rotations into Industrials and Financials since the March 23rd lows, and we’ve been in a middling fourth one since August 6th. We measure that by looking at the relative 10-day return performance for large cap Technology relative to Industrials and Financials.
#2: Let’s look at that 10-day rolling return comparison for Tech versus Industrials. The YTD chart immediately below (periods of Tech outperformance above the line, Industrial below) shows the following phases:
- Setup: the March crash that ended on the 23rd. Tech outperformed Industrials by 11.5 percentage points over the 10 trading days that ended with the market bottom.
- First rotation into Industrials (March 23rd to April 28th): Industrials did well both off the initial bottom (the 10 days after the lows) and again in the second half of April, each time outpacing Tech by 4-5 points.
- Second rotation (May 12th to June 8th): Convinced that a US reopening would go smoothly, the market once again rallied Industrials over Tech, and in the 2 weeks leading up to June 8th they outperformed Tech by 14 points.
- Third rotation (June 22nd to July 23rd): Hopes that Q2 earnings season would exceed expectations lifted Industrials one more time, with 10-day returns ended July 23rd beating Tech by 9 points. Actual results were not, however, much better than Street estimates (-84% comp versus -90% expected).
Bottom line: we’ve been in a minor 4th Industrial rotation since August 6th (trailing 10-day returns beating Tech by 6 points), but today was a setback (losing almost 1 point).
#3: The story for Financials is virtually identical to Industrials, except this group has generally lagged when the market has staged any one of its cyclical rotations since March 23rd. Just below you will find the 10-day relative performance of Financials to Tech. Two thoughts on what is going on:
- Industrials have a clearer path to outsized incremental profits, namely cost cutting and marginal sales in a recovery. The investment case for Financials is less clear since they are more levered to the US consumer economy and unemployment is still high.
- Ultra-low interest rates are also a headwind for Financials, limiting their long run earnings power and therefore valuations.
Bottom line: even during what seem to be highly correlated cyclical rotations since the March 23rd lows, markets are actually differentiating between economically sensitive groups.
Final thought #1: of these two cyclical plays, we far prefer Industrials to Financials. The earnings upside for Industrials is clearer, and peak earnings can come sooner given cost cutting.
Final thought #2: cyclical rotation in the current cycle is much like the old saying about beauty, namely that it is in the eye of the beholder. Over short periods of time, cyclicals can and have worked. Catching these moves, however, is challenging at best.