Spinning Tops – When Euphoria leads to Sector Rotation

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The markets are currently trading on euphoria, strong confidence, and high expectations. They are at all-time highs with multiples at highs as well. As a team, we are believers in “sector rotation”. A break in optimism could cause corrections and we expect to start seeing industry sectors rotating out of the euphoric state before the end of the first quarter of 2018.

 

What is driving the market upwards?

Many positive indicators are driving the market upwards. Innovations in technology, high-GDP numbers, improving retail sales and inventory numbers as well as potential new tax legislation are all creating positive sentiments. Fundamentals are looking good with strong global trade activity and good company revenues.

Following Trump’s election, global markets rose due to his promises of increased spending on infrastructure and tax reforms. Deregulation, cutting taxes and infrastructure investment programs all suggest future growth.

The rebuilding of infrastructure after the fires in California and hurricanes throughout the world will also affect spending. This effect will be seen all the way from retail level up to large redevelopment companies – from gas and electric companies all the way up to corporate lease companies and those involved in building expansions.

 

Less than positive indicators

High expectations may be dashed as anticipated business development is not as good as expected and optimism about tax cuts may be overblown. Treasury Secretary, Steven Mnuchin believes that the stock market will tumble if tax cuts are not passed. It probably won’t be due to this alone but there are other signs that can’t be ignored.

As a team, we believe we’re going to see major sell-offs (in specific sectors) as investors rush to get rid of stocks when their expectations are disappointed. The overall market may not see a massive downturn; however; This can be temporary very punishing to stocks.

 

Anticipations can work against you

Positive sentiment is good but unrealistic anticipations can work against you. Hope in Trump’s policies may offer disappointment because it’s unclear what will be accepted by Congress or not and his programs are deficient on details.  Swift action may be taken as investors attempt to rid themselves of stock. Sometimes a 3% earnings miss can cause a stock to fall by 20 or 30% or even more.

It’s also important to be aware of “technical trend gap-downs” on security prices. The fact that markets are betting on fundamentals should also be taken with caution and fundamental deteriorations will only be magnified on the way down.

 

Rotations out of ‘hyped-up’ sectors

As a team, we do not suggest a complete market selloff, but we are calling for rotations out of drug and pharmaceutical stocks and other sectors that are too ‘hyped up’. Margin shrinkage is likely to occur in healthcare companies, specifically drug companies.

Hillary Clinton managed to drive biotech stocks right down with a single tweet, after which she embarked on a war against big pharma that would create a bear market for this industry. The Trump administration wants to eliminate some of the value of patents which will affect IP-heavy industries the most.

We see positive expansions of multiples and continued revenues in the rebuilding of physical structures and in technology. We also see expansion in spending when it comes to security and other factors related to the safety of the American population.

Our team believes that within the next six months industries will start breaking the trend. A 3% reduction in numbers can result in a 30+% reduction in share prices.

 

The influence of politics on the market

Politics is a bit of a wild card when it comes to the markets, but it often has less influence than we might expect. One would expect the terrorist attacks, threats of nuclear war and extreme weather events experienced recently to have a negative effect on the markets. This would have happened in the past, but today’s markets seem to be more resilient. An initial knee-jerk reaction may occur, but it usually doesn’t last. We believe this is a temporary rotation.

Industries that look strong over a long period

Some industries look strong over a long period of time. Banks have rallied, and we believe they will continue north.

The huge impact of the Texas and Florida hurricanes and the California fires will drive years of construction and infrastructure spending. We expect increases above 2+ % a year as companies start to benefit from ongoing work in rebuilding infrastructure and private homes. (There is already a 4-year backlog when it comes to the rebuilding of homes in California!).

Real estate plays a big role in the US economy and it is looking strong, benefiting from demographics and popular culture. Watching HGTV has had an influence on Millennials who want to buy their own homes and are probably better informed than previous generations about all the options available. House flipping is becoming popular again, especially in CA.   Companies catering to this generation’s buying potential are likely to flourish.

When it comes to the stock market, there are numerous factors that influence losses and gains, including company earnings, interest rates, and global economic expectations. Losses and gains can’t be attributed to one factor alone. However, corporate earnings growth is a big driver of market growth.  When company profits continue to grow, the market is sure to follow.

Betting against America can be dangerous and, so we think that this is specific to industries at this point. Our advice as a team is not to sell off altogether but simply to rotate out of ‘over-hyped’ sectors and into others where there is likely to be an increase in spending. Construction and security are two such sectors that are likely to show continued growth.

(Thoughts by John Valentine of John Valentine Research and Associates, former Hutton and GE Capital Kidder and Valentine Wealth Advisor from UC Davis and by Mike Dotterer, former Stanford and Columbia University Graduate. Input was also received from Steve Fluke, former graduate of San Jose State and business entrepreneur).