With the S&P 500 Index up modestly for the year and only a few points off its all-time highs, as of mid-April, and with volatility (VIX¹) levels near their lows, it would appear on the surface that US equities are steadily marching forward.
Beneath the surface, however, a sudden and fairly violent internal rotation has taken place in recent months. Essentially, the leading areas that were driving the market throughout 2013 and early 2014 — including Internet, biotech, growth and small cap — became major laggards in mid-March. At the same time, the 2013 laggards — including utilities, energy, value and mega caps — have become market leaders.
So what caused this rotation, how long will it last and what does it portend?
A likely reason for the shift in stock leaders is that valuations of some of the “high flyers” had become too stretched, making these stocks especially vulnerable to any disruption to the status quo. Fed² Chair Yellen’s comments that the Fed might raise interest rates in “about 6 months” after ending QE³ was a convenient excuse for many investors to take profits in these extended leadership names.
The duration of this rotation, given the amount of carnage experienced by many of these stocks, will likely take several weeks of consolidation to heal the damage. We are likely to see more stock-specific differentiation within former leadership groups, such as the Internet and biotech sectors, as opposed to a rising tide lifting all boats.
As for broader market implications, time will tell. Some pundits have noted that most major market tops have often begun with the sort of leadership shifts we have just experienced. While this is true, there are also many instances where such a rotation has been a false alarm, and the market has continued to power higher. It will be important to monitor the internals of the market closely over the coming weeks and months to gauge its health. To remain constructive on the broader market, we will be looking to see solid market breadth, better small-cap participation and stocks reacting well to positive earnings surprises.