Rate Worries Key Sector Rotation

9/25/2017


Fueled by optimism about the global economy, the Dow Transports and other cyclical stocks have strengthened. But shares of bond proxies like utilities and consumer staples have dipped amid a bounce in bond yields, reflecting worries about the Federal Reserve's plans to unwind its easy-money policies. For now, our buy lists have 94% to 97% in stocks.

Bond-market worries

The Dow Transports have rallied to within 1.5% of their July all-time high of 9,742.76, with strength in air-freight names complementing a continued surge in the railroad and trucking groups. FedEx ($221; FDX) reported a disappointing quarter and guidance, mostly because of a cyber attack. But the air-freight giant said it expects the best year for global trade in years, sending its shares and the industrial sector to all-time highs.

The materials sector, benefiting from higher commodity prices, has also reached new highs. Bank stocks have rebounded from lows reached in early September, helped by a bounce in bond yields. Higher yields are expected to lift banks' profit margins by increasing the gap between what they pay on deposits and charge on loans.

As expected, the Federal Reserve left short-term interest rates unchanged after its Sept. 20 meeting. But the Fed announced the beginning of a plan to shrink its bond portfolio. While the move was widely anticipated, investors worry about the risk of a policy mistake. In 2013, after the Fed indicated in May that it planned to scale back its bond-buying program, 10-year Treasury bond yields nearly doubled to 3% by year-end.

Even with a robust global economy, that type of spike in bond yields is likely to weigh on stocks. Financials and cyclicals should hold up relatively well, while defensive and rate-sensitive groups are likely to suffer the most.

Already, the Dow Jones Utility Average has dropped 3% from the all-time high reached Sept. 11. The rate-sensitive real estate sector has also slumped, as has the defensive consumer-staples sector. Partly because low bond yields have pushed income investors into bond-like stocks, these areas remain unusually expensive relative to historical norms.

Our buy lists have relatively little exposure to these expensive low-volatility stocks. But, for the sake of the market's health, we'd prefer to see both defensive and cyclical groups moving higher.

Conclusion

A close above 9,742.76 in the Transports would reconfirm the bullish primary trend under the Dow Theory. Continued strength in the broad market, as seen in S&P 1500 advance-decline line, would also be encouraging.


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