HIGHER BOND YIELDS AND A STEEPER YIELD CURVE PROBABLY ACCOUNT FOR RECENT STOCK ROTATIONS INTO FINANCIALS AND CYCLICAL STOCKS -- THAT MAY ALSO EXPLAIN RECENT BUYING OF SMALL CAPS AND TRANSPORTS -- AND WHY FINANCIALS ARE THE PAST MONTH'S STRONGEST SECTOR
HIGHER BOND YIELDS STARTED ROTATION INTO FINANCIALS AND INDUSTRIALS... My message from two weeks ago (October 25) suggested that the recent rise in bond yields and the steeper yield curve over the last two months may explain several rotations with the stock market. The main focus was on financials which have been the biggest beneficiaries of higher bond yields. But also mentioned were economically-sensitive stock groups closely tied to the economy -- like small caps and transportation stocks; as well as cheaper value stocks in general. At the same time, rising bond yields should cause a rotation out of dividend-paying bond proxies like staples, utilities, and real estate. Several of those rotations have taken place since then. Yesterday's message showed small cap and transportation stocks nearing their highest levels of the year. Today's article looks at four others.
The lower box in Chart 1 shows the 10-Year Treasury Yield ($TNX) bottoming near the end of August and rallying during the first half of September. A second (higher) bottom was formed near the start of October before turning higher during the rest of that month and into the first week of November. The TNX is trading 8 basis points higher today to 1.86% and nearing the highest level in nearly two months. The vertical lines compare those two TNX bottoms to two relative strength ratios that turned up at the same time.
The upper box shows the Financial SPDR (XLF)/ S&P 500 ratio turning up with the two bottoms in bond yields (see circles). The middle box shows the Industrial SPDR (XLI)/SPX ratio doing the same. Both sectors have hit new records over the past week as investors have bought shares that should benefit from a stronger economy and higher bond yields.
RISING YIELDS HURT REITS AND UTILITIES...Money rotating into more cyclical stock groups over the past two months has been moving out of more defensive dividend-paying stock groups that usually do worse when bond yields rise. We're focusing on two of them below which have become the market's weakest performers. The red line in the upper box in Chart 2 plots a relative strength ratio of the Utilities SPDR (XLU) divided by the S&P 500. The two green vertical lines correspond to the two bottoms in bond yields as shown in the previous chart. The top line shows utilities underperforming both times bond yields bounced (red circles). The second TNX upturn since the start of October has pushed the XLU/SPX ratio to the lowest level in three months.
The middle red line in Chart 2 plots a ratio of the Real Estate SPDR (XLRE) divided by the S&P 500. The two red circles show the ratio turning down at the green vertical trendlines which coincided with the two bottoms in the 10-Year Treasury yield. Although the two red ratio lines fell together, real estate has fallen even harder than utilities. But the message in both cases is the same. Investors have been rotating out of bond proxies as bond yields rise and bond prices fall. That includes consumer staples.
MONTHLY LEADERS AND LAGGARDS... Chart 3 ranks sector relative performance over the last month, and shows those recent rotations more clearly. Financials (XLF) were the month's strongest sector, and hit a record high. Industrials (XLI) were in second place and hit a new record as well. The XLI also benefited from rising transportation stocks. Energy, Technology, and Materials also had a strong month. Technology (XLK) hit a new record, as did Materials (XLB). The XLB was led higher by economically-sensitive copper, aluminum, and steel stocks; while safe haven gold miners lost ground. The three weakest sectors for the month were Real Estate (XLRE), Utilities (XLU), and Consumer Staples (XLP).
Small cap stocks outperformed large cap stocks during the month, and benefited from rising financial shares which are the biggest part (18%) of the Russell 2000. Those rotations appear consistent with a climate of rising bond yields (and a steeper yield curve) over the last two months which suggest a stronger economy and stock market. And favors stocks that benefit the most in that environment.
