- Two defensive sectors had outperformed the broad equity market
- But it recently endured significant selling pressure
- Important signals can be visible in the rotation of the sector
- Crash in market hiding places S&P 500 one step closer to a tradable low
Two sectors that had outperformed for much of 2022 were and . The narrative made some sense: hard assets should do well during inflationary times and the consumer was still strong, so house prices and rents should perform relatively better than, say, cyclical chip stocks or industrial games.
In the utility space, stable and reliable (some would say boring) electricity providers and companies that own major power transmission lines shouldn’t be affected by an economic downturn. So those groups did well when other stocks tumbled. Real estate and public services show better returns until September.
Massive relative collapses in real estate and utilities
Annual real estate and utility returns
Source: Goldman Sachs Investment Research
New variables have shattered that thesis. First, the highest mortgage rates in 22 years, above 7% as of Monday afternoon, are sure to cause at least a short-term depression in real estate transactions, hurting some REITs. Furthermore, history shows that even real estate companies can be as volatile as S&P 500 when times get really tough (see 2008).
Rising Mortgage Rates Hit Residential REITs
Source: Mortgage News Daily
Meanwhile, the utilities sector had tanked over the past month against the SPX, underperforming by 20% or more, due to the latest rate hike. Perhaps the move from 3.5% on the Treasury curve to 4% or more will change the ball game for high-yield utilities. Now there is a safer alternative. Hello Tina.
The US bond market fell for 11 consecutive weeks
Source: J.P. Morgan
So what does this mean for investors and what moves should they make? Well, I see the latest round of selling focused on these more defensive niches as a positive sign towards an eventual market bottom. Think of it this way: For stocks to fall and capitulation to occur, we need everyone to be in the bearish group. Both top performing industries and ultra-washed names should go down together. Perhaps this is an initial step in that bottoming out process.
Another thing that can provide clues as to where we are in the market cycle is looking at industry turnover trends. During an inflationary environment, the Utilities and Real Estate sectors are thought to tend to outperform just before the market bottoms, according to Sam Stovall. S&P Sector Rotation Guide. That superior performance is gone. Are we reaching the bottom of the market as a result? Unknowable, but keep an eye on financials (now outperforming) and then sectors and for new leadership before we can be confident of a true low.
Sector Rotation: Beyond the Peak in Utilities and Real Estate Relative Strength
The bottom line
While everyone is focused on earnings season, the Fed, and what mega-cap growth stocks are doing in the coming weeks, keep an eye out for two small and somewhat defensive market dots. Real Estate and Utilities, which were positive from a year ago in relative terms for much of the third quarter, are now recovering. It could be a sign that the market cycle has taken another step towards a market bottom.
Disclaimer: Mike Zaccardi does not own any of the securities mentioned in this article.