S&P 500 Velocity Seen in Best Defensive Rally Since 2011

American companies with earnings least tied to the economy are beating so-called cyclical shares by the widest margin since August 2011, a sign that almost always means a bull market will accelerate.

Defensive shares such as Johnson & Johnson and Procter & Gamble Co. have rallied 19 percent on average in 2013, the best start since 1991, according to data compiled by Bloomberg. Defensives exceeded cyclical stocks by more than 8 percentage points last month, the most in 20 months, JPMorgan Chase & Co. data show. As long as the economy isn’t shrinking, gaps of that size have presaged rallies of 10 percent in the Standard & Poor’s 500 Index since 1973, according to JPMorgan.

Bulls say investor preference for stocks that do better in sluggish economies is a contrarian indicator that’s already giving way to bigger gains among technology and energy shares. Bears say the trend shows investors are losing confidence at the same time as chief executive officers, who have lowered earnings forecasts at the fastest rate for any first quarter since 2001, data compiled by Bloomberg show.

“Contrarian theories often work because if everyone is committed to one side, then there’s not much more firepower left,” Donald Selkin, a 37-year Wall Street veteran who helps manage about $3 billion of assets as the chief market strategist at National Securities Corp. in New York, said in a May 3 phone interview. “We could see a change in leadership in the market if the perception becomes that the economy is strengthening.”

Cyclical Revival

The S&P 500 advanced 2 percent last week to 1,614.42, as home sales rose, jobless claims unexpectedly fell and profit at companies from Avon Products Inc. to Seagate Technology Plc beat analyst estimates. Technology shares and energy stocks led the gains for a second week after trailing the market for the previous five, data compiled by Bloomberg show. The S&P 500 added 0.2 percent to 1,617.50 at 4 p.m. New York time today.

Individuals and funds have poured money into drugmakers and household-product suppliers, speculating they provide safety because their products are in demand whether the economy shrinks or expands. The buying is mirrored in investment in exchange-traded funds that track stock indexes.

Outstanding shares rose by 17 percent this year in the biggest ETFs for health-care and consumer staples companies, whose largest holdings are New Brunswick, New Jersey-based J&J and Procter & Gamble in Cincinnati, according to data compiled by Bloomberg. Investors liquidated holdings in the largest energy ETF and the Powershares QQQ Trust, which own Exxon Mobil Corp. in Irvine, Texas, and Cupertino, California-based Apple Inc., the data show.

Bullish Signal

Outperformance by defensive industries has been a bullish sign for the S&P 500 in past bull markets, with the index gaining eight of 10 times over the next quarter, according to industry baskets compiled by JPMorgan. When defensives led by a margin approaching last month’s, in July 2009, the S&P 500 gained 22 percent.

Defensives beat cyclicals during the September 1998 collapse of hedge fund Long-Term Capital Management LP and its bailout by a group of Wall Street firms and the Federal Reserve. The S&P 500 lost 19 percent between July 17 and Oct. 8 in 1998. A group of utilities, phone companies, health-care stocks and household-product suppliers exceeded cyclicals by 8.2 percentage points in the four weeks ending Oct. 9, JPMorgan data shows. The S&P 500 gained 30 percent over the next 90 days, the data show.

‘Human Nature’

“This is human nature,” James Paulsen, who oversees $325 billion as the Minneapolis-based chief investment strategist at Wells Capital Management, said in a May 1 phone interview. “If you’re a risk-averse investor already, you come into the market slowly. It’s only once you’ve been in for a while and the market’s been treating you well that you get more aggressive.”

Defensive industries are rallying as the market enters a period that has seen its biggest declines over the last three years. The S&P 500 has posted an average loss of 15 percent starting in April since 2010, data compiled by Bloomberg show. No such retreat has occurred this year. The benchmark gauge for American equities is up 13 percent, rising every month since October, and closed at records four times last week.

At the same time, earnings growth is slowing. Profits in the S&P 500 are forecast to rise 2 percent in the quarter ending March 30. That compares with 4.7 percent on average last year and 25 percent in 2010 and 2011, Bloomberg data show.

About two companies have predicted earnings will be below analyst estimates for each that says they will be above forecasts since April 8, according to data compiled by Bloomberg. The ratio is twice as high as in the last three years.

Vulnerable Market

The S&P 500’s advance makes it more vulnerable to disappointing economic growth and Europe’s recession, according to Thomas Garcia of Thornburg Investment Management Inc., which manages $80 billion. At 15.8 times annual earnings, the index’s valuation is higher than any time since 2011, data compiled by Bloomberg show.

The U.S. and Chinese economies grew less than forecast last quarter. The European Central Bank cut its key interest rate to a record low last week, as manufacturing output contracted in April for a 21st straight month, according to figures from London-based Markit Economics.

“I don’t think Europe’s out of the woods yet, and you’re starting to see a slowdown in China, which is definitely worrying some people,” Garcia, head of equity trading at Santa Fe, New Mexico-based Thornburg, said by telephone May 2. “I’m still worried going forward. There are definitely things to be bearish about.”

Defensive Buying

Individuals have added shares in companies whose earnings are least reliant on economic growth to make up for declining bond yields. The average dividend payout on defensive stocks in the S&P 500 is 2.7 percent, compared with 1.8 percent for so-called cyclical shares, according to data compiled by Bloomberg. That compares with rates on 10-year U.S. government notes of 1.63 percent.

Investors are collecting less on government bonds from the U.S. to Germany and the U.K., which are near negative returns after accounting for inflation. So-called real yields on 10-year Treasuries are about 0.15 percent. Similar measures are negative 0.03 percent in Germany and negative 1.17 percent in the U.K.

“There’s a lust for yield that exists around the world, both from institutions and individuals,” John Stoltzfus, chief equity strategist at New York-based Oppenheimer & Co., said in a May 2 phone interview. “If they can’t get it in bonds, where do they go? It’s moving to equities, and the first place is those proxies for fixed income: telecom, utilities, large-cap pharma.”

Consumer, Technology

While defensive stocks led this year, industries with earnings tied to the economy have generated the biggest returns since March 2009. Consumer discretionary shares are up 250 percent, followed by banks at 203 percent, industrial companies at 175 percent and technology suppliers at 136 percent. Phone companies have the smallest return at 88 percent, while power producers gained 89 percent.

At 18.8 times annual profits, defensive industries are trading at a 19 percent valuation premium to the market, according to data compiled by Bloomberg and Morgan Stanley. Shares of defensive companies have returned the least in every bull market since at least 1990, according to data compiled by Bloomberg and Birinyi Associates Inc. in Westport, Connecticut.

“Contrarian investing may be another way of saying that valuations matter,” Stephen Wood, who helps manage about $163 billion as the New York-based chief market strategist for North America at Russell Investments, said by telephone on May 3. “Right now peace of mind has gotten very expensive.”

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