Santoli: Stocks enter fourth quarter playing offense

Published Sun, Oct 2 20166:46 PM EDT

The headlines are enough to keep any investor in a defensive crouch—a vicious presidential campaign, Federal Reserve policy in constant flux, Deutsche Bank wobbling uncomfortably near the center of the world's financial system. Yet a careful look at the stock market itself shows that it's transitioning subtly toward an offensive footing. The broad Standard & Poor's 500 index has made no net progress for 11 weeks, closing Friday just three-tenths of one percent above where it sat on July 15. Yet many of the better-performing areas of the market over this span have been sectors that benefit from better economic growth and rising investor risk appetites. Here's a selection of what's been working since July 15, as the S & P has flat-lined: The PHLX Semiconductor Index is up more than 15 percent. Industrial-machinery stocks have climbed to a new record, helped by an 11 percent surge to a new 52-week high by Caterpillar ( CAT ). The Dow Jones Transportation Average has started outperforming the market, especially in the past couple of weeks. And equities in developing markets, as tracked by the iShares MSCI Emerging Markets ETF ( EEM ), have advanced by 5 percent. This is a reversal of the pattern of earlier this year, when it was largely the steady, boring, "high-quality/low-volatility" stocks with richer dividends and less exposure to the economic cycle that held the market up. The S & P 500 Low Volatility fund ( SPLV ), which became popular as a way to participate reluctantly in equities via "safer" stocks, is off 3.5 percent since mid-July. Within this universe, big pharmaceutical stocks are off 5.7 percent in that time and the S & P utilities sector down 5 percent. The ETF on the other end of the spectrum from the staid low-volatility grouping—the S & P 500 High Beta fund ( SPHB )—has been ripping, up 6.6 percent in those 11 weeks. S & P 500 High Beta fund vs. S & P 500 Low Beta fund, 3 months Source: FactSet Chris Verrone, a technical market strategist at Strategas Research, notes that the S & P High Quality index of "safer," more stable companies hit an eight-month low relative to the benchmark S & P 500 last week, despite continued declines in Treasury-note yields. "This marks a change in character from how quality defensives, and the low-volatility corners of the market have responded in the past and it deserves attention moving forward," Verrone says. What might this character shift mean, then? Is the stock market sniffing out a budding acceleration phase in the U.S. or global economy? The idea of an emerging economic "firm patch" is plausible, if not wholly persuasive. Over recent years as U.S. GDP has averaged around 2 percent, it has alternate between stall-speed periods of 1 percent growth and stretches of closer to 3 percent. The first half was weak, but last week economists at Barclays and Goldman Sachs revised estimates for the just-ended third quarter up to 2.6 and 2.8 percent, respectively. Consumer confidence gauged by the Conference Board made a new nine-year high, and the labor and housing markets continue to look firm. But, oddly, consumer-discretionary stocks have been conspicuous underperformers outside of Amazon . So it's not as if investors are eagerly pricing in a domestic spending resurgence. So are we simply back in a "risk-on" market, with money rotating toward stocks that have lagged but have more "juice" for some potential year-end excitement? This certainly could be happening. There's a widely circulated idea that fund managers chase high-octane stocks into year end to goose their performance. While Bank of America Merrill Lynch last week debunked the idea that such high-beta stocks truly do outperform at year's end, traders my take a shot at them all the same. The return of 2015's FANG trade—in which a few dominant mega-cap tech stocks were responsible for holding the market up—is one much-noted feature of the market since mid-year. The Nasdaq 100 —with a combined 40 percent weighting in Apple , Alphabet , Amazon, Microsoft and Facebook— is up more than 6 percent since July 15. Yet the market's advance this year has been far broader, and thus healthier, than it was late last year, when most stocks were in ugly downtrends, their weakness obscured by the few glamour stocks. If the market in general is poised for a long-awaited revival of earnings growth near the end of this year, then arguably the way to position for it is in the more cyclical, faster-moving stocks. (While the overall S & P 500 is now forecast to show another year-over-year drop in profits for the third quarter, of a bit more than 2 percent, the "usual" pattern of upside surprise offers a shot at pulling even.) Most industrial, energy and transportation names are still far below their all-time highs of 2015 or even 2014, despite their recent strength. So money could simply be flowing toward sectors where earnings have the greatest room for recovery. This subtle transfer of power within the market toward cyclical and momentum-tech stocks comes at an interesting moment for professional investors. The broad market is on track to deliver the sort of mid-to-high-single-digit percentage return this year that the consensus roughly expected—yet it had to overcome a couple of intense scares long the way. In no year since 1950 has the S & P 500 been up through Sept. 30 and not finished the year with a gain —and 84 percent of the time when it was up on this date, it has added to those gains in the fourth quarter. This might be giving investors a bit of confidence that things are not primed to fall apart imminently—even if October can be nasty, especially in contentious election years, and even if the financial system and central-bank policies have the worriers' brigade on high alert. Maybe the recent leadership by economically sensitive sectors is yet another head fake or false start by the growth bulls. Or might the tech and industrial economy just be getting a bit better, at least for a while?

A stock chart is displayed on a terminal as traders work on the floor of the New York Stock Exchange.

Daniel Acker | Bloomberg | Getty Images

Yet a careful look at the stock market itself shows that it's transitioning subtly toward an offensive footing.