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For Now, It’s a Sideways Market

Despite all the volatility, markets haven’t moved much and sector leadership hasn’t changed. Investors should be prepared for a shift.

Markets have tumbled in recent trading sessions, but year-to-date, the S&P 500 is nearly flat. The rapid gains of early January were erased in February and March so far might best be described as choppy.

I don’t expect this pattern of heightened volatility and a sideways direction to change anytime soon. A look at the underlying sector performance of the S&P 500 explains why I think there is little confirmed direction in stocks, but investors should be prepared for a shift.

I’ve characterized this period in markets as a regime change, where stronger government stimulus and a pullback in support from central banks would lead to higher interest rates and a shift in stock market leadership to more defensive sectors. But while interest rates have risen, a sign fixed income markets have adjusted, stock markets haven’t responded as I expected yet.

Normally, stock market leadership in these conditions would favor economically cyclical or value stocks like energy, materials or financials. Instead, equity leadership has remained entrenched among many of the same technology and consumer discretionary names that have been leading the market for years. Market breadth has narrowed with the top 10 largest stocks accounting for about 45% of the gains so far this year, compared to 33% in 2017 and 27% in 2016.

This narrowing is not what I like to see. It suggests that equity investors aren’t convinced that broad economic growth is sustainable and therefore are focusing on the small group of leaders that can achieve strong earnings growth even when overall economic growth is tepid.

There is also a chance that equity investors’ response to regime change is just lagging and will still occur if and when earnings growth starts to decelerate. There is also a chance that investors no longer see higher interest rates as a reason to lower their expectations for winner-take-all tech and consumer names. These category killers may be so dominant that their results swamp traditional sector characteristics. Another possibility is that changes wrought by technology have rendered traditional sector definitions obsolete, blurring categories and requiring strategists to focus on stock-level analysis.

Bottom Line: Given the mixed signals, I expect the market will continue to churn and be volatile for the time being. Investors should pay close attention to earnings momentum and watch for a shift in market leadership that may signal a new direction.

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MORGAN STANLEY ACCESS INVESTING