Anticipatory Moves
The S&P 500 is up 26% year-to-date, as the election results continue to get factored into the markets. November 5th saw a “red-sweep” and stocks have rallied modestly since then, up 4.6%. Not many saw, nor predicted, the clean sweep by the Republicans. But beneath the surface of the broad market’s price performance in the months leading up to the election some of its sectors were perhaps indicative of that sweep. We’ll take a look to see what happened and where things might be moving from here.
Over time the market tends to be a leading indicator of the overall health of the economy as it is always discounting future earnings and cash flows back to the present. We know that it can be overly optimistic and pessimistic at various times, but on average it’s always anticipating where we’re going. And within the market you can see sectors and individual stocks moving ahead of the actual results or outcomes of events that haven’t happened quite yet, such as the Fed cutting or raising rates, or, in this case, a Presidential election. Case in point here would be the price action that we’ve seen in the financials and health care sectors. Both started moving well before the election, financials to the upside and healthcare to the downside.
Bank stocks started outperforming the S&P 500 on June 14th. Since that date, regional banks are up 47%, small banks are up 41% and the large banks, up 39%, while the S&P 500 rose 10.5% over the same period. Part of this outperformance can be attributed to the Fed’s cutting rates in September and November. The move lower in the Fed Funds rates by 75 bps helps ease banks’ funding costs. But since mid-September when the Fed cut rates for the first time, the 2-year Treasury note has moved higher by 83 bps and the 10yr note by 78 bps. The rise in long-term rates implies the market fears that inflation is likely going to be more persistent than hoped for. These relative rate moves were very significant. The slope of the curve was still deeply inverted in late June by -50 bps, but is has now dis-inverted and is positively sloped by 7 bps. This positive slope in the curve and the election outcome which bodes well for a less-heavy regulatory environment, suggest a potentially better environment for badly needed banking M&A, and an economy that is looking fairly healthy and not going into a recession. It easily justifies the rally in banks. As well, banks won’t be directly impacted by any potential tariffs. This is a good example of stock prices anticipating key moves in the markets that hadn’t happened yet – in this case the dis-inversion of the 2s-10s curve and the election outcome that’s an overall strong positive for banking.
The health care sector tells a different story. It was having a really decent year through the end of August – up 16.3% YTD compared to the S&P 500 being up 19.5% at that same time. Since then, the health-care sector has rolled over and is lower by 7.9% while the S&P 500 is up 6%. This looks like the collective market recognizing that a Republican win looked increasingly likely and that in turn would mean new health care policy uncertainty. Importantly as well, health care stocks are sensitive to higher rates, as they are in aggregate considered long-duration assets. The 10yr has moved higher by 78 bps in the last two months putting pressure on the funding costs for the vast number of firms in the small- and mid-cap biotech space. The health care sector YTD is the weakest, up 7% compared to the S&P 500 up 26%.
So, what are some implications for the markets going forward? We still like the outlook for bank stocks because they still have very attractive valuations and because of the more pro-business outlook from Washington. And the current uncertainty overhanging health care stocks will likely be with us for a few more months, but we still like the group and think they’ve been mispriced lower by an overly pessimistic market. As for the broad market, it’s currently trading at 21.6x next year’s earnings. Not cheap relative to itself going back ten years at 17.6x, but when you factor in the possibility of lower taxes and a less-heavy regulatory business environment the market, it doesn’t look quite as expensive. And much of the market looks quite reasonable when you factor in that a small number of very large, fast-growing tech companies, which may deserve high multiples, distorts the overall multiple by about 3 multiple points.
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