Reviewing sectors, it becomes clear that this was not a uniform selloff with high correlations. Utilities and real estate were in fact positive because of their sensitivity to interest rates which moved lower. The 10-year U.S. Treasury yield decreased 0.11% to close at 2.22% while the 2-year U.S. Treasury yield closed at 1.25%, bringing the spread between the maturities to less than 1% for the first time since the election. Financials bore the brunt of the drop in yields and flattening of the yield curve as they fell 3%+.
Moving past interest rate considerations, the selloff displayed a classic “de-risking” in which the most volatile sectors performed the poorest including technology losing 2.7%. Tech has been the best performing sector during this historically calm year (see bottom of this week’s graphic); however, that lack of volatility could be misleading as noted by Convergex. The CBOE Volatility Index (VIX) has been flat at historically low levels, but the “VIX” of large cap tech stocks (as determined by option pricing) is up 10% over the last month. The move is especially meaningful given tech’s importance to the market, asset managers, and retail investors. The tech sector comprises 22% of the S&P 500 as well as three of the top four holdings (Apple, Microsoft and Facebook). Due to its post-recession performance record, it has become the preeminent sector for overweighting for outperformance. “Put another way: forget the VIX and focus on tech stock options pricing.” Implications are that the market isn’t as complacent as it appears.
What could further political turmoil mean?
The biggest risk factor is that an investigation would derail or postpone legislative efforts for tax reform, infrastructure spending, etc. Corporate earnings are on track for a 13.9% increase from the previous year per FactSet, but with valuations elevated, fiscal reform would provide another viable path for a move upward for the market. There’s also the “soft data” aspect of a steady stream of stories negatively impacting business optimism and consumer confidence. As far as potential impeachment is concerned, the two cases in modern times (Clinton and Nixon who resigned) faced opposition parties while Trump has Republican majorities in the House and Senate, making that scenario very unlikely.
The major stock indexes recovered approximately half of their losses on Thursday and Friday. Investors were able to refocus from the political turmoil to continued positive earnings announcements and economic data. The Conference Board Leading Economic Indicator (LEI) which compiles ten components to signal peaks and troughs in the business cycle climbed to a new high based on April data. “The recent trend in the U.S. LEI, led by the positive outlook of consumers and financial markets, continues to point to a growing economy, perhaps even a cyclical pickup,” said Ataman Ozyildirim, Director of Business Cycles and Growth Research at The Conference Board. Doug Short from Advisor Perspectives smooths out and tightens up the indicator by using its six month rate of change. The LEI has historically dropped below its six month moving average between 2 to 15 months before a recession. The latest reading suggests no near-term recession risk.