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Is rising uncertainty a sign of a more favorable market outcome?

What are Defensive Sectors?


Because of the constant demand for their products, defensive sectors perform relatively better than their economically sensitive counterparts during market uncertainties and a declining market. Utilities, Consumer Staples, and Health Care select Telecommunication Services, and some REITs are classic defensive sectors.


Defensive sectors are stable, less volatile, and can withstand changes in economic fluctuations. They are necessary goods and services and are needed in all phases of the business cycle. Consumers will buy them even when the economy is slowing or contracting.

Investors tend to buy these recession-proof sectors to hedge their stock portfolio against a stock market decline or a broad market correction. Defensive sectors stand to perform better than their peers during a market correction or a bear market decline. The trade-off is that they will underperform the higher-risk, cyclical industries, and growth areas during a rising market environment or strong recovery.


S&P 500 sector rotations typically trade in unison with one another


The recent sector rotations within the key S&P sectors are becoming increasingly confusing. Typically, S&P sectors tend to move together in unison. For instance, cyclical sectors will trade in the general direction with similar sectors. Likewise, defensive sectors tend to trade in sympathy with their sister defensive sectors. In theory, during economic expansions and stock market bull rallies, the cyclical sensitive sectors should lead their peers in unison. Likewise, during economic slowdowns or stock market bear declines, the defensive sectors should also lead together.


S&P defensive sectors currently showing mixed readings


On the Relative Rotation Graph (RRG) for the eight (8) weeks ending August 30, 2021, it is unusual to find two (2) defensive sectors (i.e., Utilities (XLU) and Healthcare (XLV)) trending higher. During the same period, it is equally surprising to see three (3) other defensive sectors (i.e., Communication Services (XLC), Real Estate (XLRE), and Consumer Staples (XLP)) trending lower.


It is also controversial to see the two most defensive sectors, Utilities (XLU) and Consumer Staples (XLP), trading in opposite directions. XLU is rising within the Improving Quadrant, and XLP is declining within the Lagging Quadrant.


So, what does sector divergences mean?


One possible interpretation of the sector rotation divergence within the defensive sectors suggests investors are unsure of the sustainability of the economic recovery and the duration of the current bull market rally. Because they are not convinced the economy and stock market have peaked, they may be selectively buying some and not all of the defensive sectors.


Interestingly, you also see a similar divergence developing within the economically sensitive S&P sectors. Investors are also sector and stock selective with the S&P cyclical sectors. For instance, Consumer Discretionary (XLY) and Technology (XLK) are rising within the Improving and Leading Quadrants. However, such classic cyclical sectors as Industrials (XLI), Materials (XLB), and Energy (XLE) are struggling within the Lagging Quadrant.

The uncertainties surrounding the direction of the US interest rate environment, the US Dollar, the FED tapering, and the rate of inflation may cause divergences within the defensive sectors.

The uncertainties may be confusing investors as to what are the best investment opportunities. For example, if inflation is sustainable over the long term, rising inflation can erode the value of many Consumer Staples companies. It is especially true for those companies that fail to pass on the higher costs to their customers.


The direction of US interest rates can also influence interest-rate sensitive sectors such as Electric Utilities. Rising interest rates can influence how investors invest. It makes bonds more attractive to conservative investors interested in income and yield. The high capital cost and debt levels of operating a utility tend to increase the borrowing costs as interest rates trend higher, leading to lower earnings.


Are the divergences within the defensive and cyclical sectors only temporary? Or are they warnings of increasing market uncertainties?


They say that certain things in life are unavoidable, including dying and having to pay taxes.


When investing, the outcome is often unknown. However, one thing is certain. Investors do not like uncertainty.


Conventional wisdom says uncertainty is bad for markets. It is loosely based on the theory that a rise in market uncertainty makes investors less likely to invest, driving down overall growth. Conversely, when there is a high degree of volatility, there is also the potential for high opportunity.


Many investors will pay a premium (hedge positions) to protect against actual market volatility. But few will pay for uncertainty.


It is unclear whether investors are worried about market uncertainty?


Is rising uncertainty more of a sign of an impending favorable market outcome?


We will let you ponder the above thoughts into the long Labor Day weekend. Enjoy!


Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

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