In January the stock market became dangerously overbought following the tax reform rally, and as we anticipated, a sell-off occurred:
The sell-off was triggered by rising interest rates, fears of rising inflation, and the potential of a more aggressive monetary policy by the Federal Reserve.
A worrisome sign for the stock market is that shorter-term interest rates are rising faster than long-term rates, which could lead to yield curve inversion, a condition where short-term rates are higher than long-term interest rates. The bottom panel of Chart 2. shows the ratio of the 10-year vs. 30-year yield indexes. The ratio line is steadily rising since last July, as denoted by the blue arrow:
Rising interest rates negatively impacted funds that invest in this space:
The stock market sell-off is uneven with some sectors falling faster than others. Currently, the spread of the total return between the best and the worst sectors over the last three months is 25%. Should the market continue to drop, we think that this spread will continue to widen. Conversely, if we see a relief rally by mid next week, the spread will probably become more narrow.
The industry groups with the strongest relative strength vs. the S&P 500 index are the cyclicals (consumer discretionary), financials and industrials. We’d like to highlight financial services and defense stocks (part of the industrials group) as two sectors that can potentially lead the market once the market correction ends.
We continue to like the technology sector, as well, because of its lesser dependence on changes in interest rates and because of the proliferation of disruptive technologies from robotics to intelligent software: