Market Rotation



After closing lower on Friday, the S&P 500 is now down year-to-date by a little less than 1%. Despite the decline, the index is only about 4% below the all-time highs it reached in March. While the fall has not been that dramatic so far, market bears seem to be making a lot more noise than market bulls. This is not all that uncommon for a number of reasons. Primary among them are recency bias, which we discussed recently and after a period of sustained, strong performance the bears are likely to be more vocal in the hope that they will finally be right.

At the same time, as we pointed out earlier this year it has been some time since we have seen the 10% decline that is normally associated with a market correction. While it is too soon to know if a full-blown correction is underway, we are seeing signs of rotation within the market. It does not appear that investors are pulling money from the market in general. Instead, it seems that they are reallocating their dollars from areas where there is perceived froth to “under-valued” sectors.

Many high-flying technology and biotechnology names have fallen quite sharply over the last several weeks. After very strong performance in 2013 as well as earlier this year, companies such as Twitter, LinkedIn, SolarCity, Netflix, Isis Pharmaceuticals and Tesla have seen their shares fall more than 25% from their highs. These declines likely reflect several possible factors: the market was unlikely to rise at last year’s pace again; the market’s appreciation has outstripped the pace of earnings growth; after five years, the bull market could be nearing an end; and the economy could be losing steam.

Some of these points of view likely have more validity than others. However, it appears that the risk appetite for the market’s high flyers may have abated. Interestingly, not all technology and healthcare stocks are underperforming so dramatically. The names that are holding up comparatively well include older, more established companies like Microsoft, Cisco, Intel and Johnson & Johnson. These companies have stronger dividend yields and comparatively more reasonable price-to-earnings ratios (P/E).

In fact, according to commentary from Yardeni Research, the performance of industries within the Information Technology and Health Care sectors in the S&P 500 from March 5 to April 7 was largely inversely correlated with their industry’s P/E. For example, Internet Software & Services, which had an average P/E of 23.9 fell 13.4%. On the other hand, Semiconductors and Semiconductor Equipment, which have respective P/E’s of 14.9 and 15.2, generated returns of 2.9% and 4.8%, respectively. Overall the sector fell 2.8% during this period.

The story for Health Care shares was similar. The sector fell 4.1% from March 5 through April 7. Health Care Technology and Biotechnology were the worst performing industries in the sector, declining 12.9% and 12.4%, respectively. The average P/E of these respective industries was 32.7 and 20.3. At the other end of the spectrum were Managed Health Care stocks, which rose 2.7%. This industry’s average P/E was 12.8.

At BWFA, on an overall basis, stocks held in client portfolios have outperformed the S&P 500 year-to-date. Our conservative approach has resulted in us avoiding the shares of the high flyers mentioned earlier. It has also led us to exit or reduce positions in some stocks as their prices appreciated and/or we became more concerned about their valuation. In general, we believe that the risks associated with owning the most richly valued stocks cause them to be not well-suited for client portfolios.