Defensive Trading Undone in $2 Trillion S&P 500 Rally

For the third straight year, rotating into defensive industries is proving to be a losing strategy in the U.S. equity market.

Chip companies led by Micron Technology Inc. and consumer shares such as Netflix Inc. are driving gains since equities bottomed on April 11, replacing soapmakers and utilities that rallied as the economy slowed. The gains reflect projections that these cyclical stocks will deliver some of the strongest earnings growth in the Standard & Poor’s 500 Index this year, based on analyst estimates compiled by Bloomberg.

The fleeting advance in defensive equities sounded a false alarm at the start of a year once again as the outlook for the U.S. economy improved. While gross domestic product contracted 2.9 percent in the first quarter, the latest data on personal spending, manufacturing and inflation have exceeded analyst forecasts. Almost $2 trillion has been added to share values since April amid gains that pushed transportation stocks, industrials and small-cap shares to records.

“We, like much of the industry, have been positioned, waiting and expecting some kind of pullback, and we got the pullback in the first quarter,” Chris Bouffard, who helps oversee $9 billion as chief investment officer at the Mutual Fund Store in Overland Park, Kansas, said July 2. “A lot of people were thinking, ‘oh, this might be the big one.’ Since then, the playbook resumed. We marched to new highs.”

GDP Growth

After shrinking the most in five years in January through March, U.S. GDP is projected to have grown by 3.5 percent in the second quarter, according to the median estimate of 81 firms surveyed by Bloomberg News.

American stocks rallied last week as a decline in the unemployment rate to an almost six-year low sent the Dow Jones Industrial Average (INDU) above 17,000 for the first time. The S&P 500 climbed 1.2 percent over the four days, extending its gain since April 11 to 9.4 percent and pushing the rally that began in March 2009 to 193 percent. The gauge slipped 0.4 percent to 1,977.65 at the close in New York today.

Concern the Federal Reserve’s withdrawal of stimulus would slow the economy prompted investors to favor industries less reliant on expansion this year. Exchange-traded funds tracking health-care and utility companies have received more than $3 billion compared with about $580 million for technology ETFs and withdrawals of $3.4 billion for consumer discretionary funds, according to data compiled by Bloomberg.

Repeat Performance

The same thing happened in 2012 and 2013. Drugmakers and power companies were among the strongest-performing sectors in March and April last year as analysts cut profit estimates for the full S&P 500. Twelve months earlier, utilities and phone companies were the best performers as the broader index slid. Both times the gauge finished the year with advances led by retailing, industrial and financial shares.

“The jobs report is clearly a sign of continued and accelerating strength of the economy,” Jeff Korzenik, Chicago-based chief investment strategist at Fifth Third Bancorp., said in a July 3 phone interview. “The cyclical leadership in many ways will become more pronounced.”

As happened last year, signs the U.S. recovery is picking up are lifting stocks throughout the market, with the Dow Jones Transportation Average (TRAN) rising to a record last week, while the Russell 2000 Index (RTY) of smaller companies came within a point of an all-time high. Such patterns are considered harbingers of gains by chart analysts who say they show economic growth is pervading different industries at the same time.

New Highs

“The stock market’s ticker tape is in gear,” Doug Ramsey, the Minneapolis-based chief investment officer at Leuthold Group, said in a phone interview on July 2. The firm oversees $1.7 billion. “This is a very broad move to new highs, which generally means that the earliest the bull market would top out is months in advance, four to six months at minimum.”

Underperformance in defensive stocks makes less sense when compared to the bond market, where yields on 10-year Treasuries have declined to about 2.65 percent from 3 percent at the start of the year, according to Oliver Pursche of Gary Goldberg Financial Services. Since the S&P 500 reached a two-month low on April 11, utilities have risen 2 percent and telecommunications companies are up 4.2 percent. That compares with more than 10 percent for technology and energy companies.

“We’re surprised that the overall risk-off attitude being reflected in fixed-income markets hasn’t caused outperformance in high-quality, dividend-paying stocks,” Pursche, president of Gary Goldberg Financial Services in Suffern, New York, said in a June 30 phone interview. “You’d expect those types of stocks to perform very well in that environment.”

Cyclical Rally

The rally in cyclical stocks has brought returns in those industries to about even with defensive companies for the full year. Since the end of 2013, health-care stocks have the biggest gain in the S&P 500 at 12.3 percent, followed by energy producers at 12.1 percent, utilities at 11.8 percent and technology makers at 9.8 percent.

For the last three months, gains have been dominated by computer and Internet companies, with the Nasdaq 100 Index rising 14 percent since April 11, compared with 6.5 percent for the Dow industrials. Profits among semiconductor makers are estimated to increase 34 percent in 2014, compared with 7.5 percent for the full S&P 500, according to analyst estimates compiled by Bloomberg. Earnings season begins tomorrow when Alcoa Inc. reports results.

Boise, Idaho-based Micron Technology, the largest U.S. maker of memory chips, has jumped 60 percent over the stretch since April 11, while movie subscription service Netflix in Los Gatos, California, is up 45 percent.

“You’re going to see a stronger market,” Robert Pavlik, who helps oversee $4.5 billion as chief market strategist at Banyan Partners LLC in New York, said in a phone interview. He owns the shares. “As the economy starts to show a slight improvement from current levels, the consumer is going to feel a lot more confident.”

To contact the reporters on this story: Joseph Ciolli in New York at jciolli@bloomberg.net; Lu Wang in New York at lwang8@bloomberg.net

To contact the editors responsible for this story: Lynn Thomasson at lthomasson@bloomberg.net Michael P. Regan, Jeff Sutherland

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