Going Beyond the Financial Headlines

We are all familiar with the recent headlines announcing new highs in the stock market. The Dow Jones Industrial Average has recently crossed 17,000 and the S&P 500 topped 2,000 for the first time. But looking beneath the surface it is clear that fewer and fewer stocks are driving the Dow and S&P higher and a look across the investment landscape shows a fatigued market struggling to gain traction after a very strong 2013.

Let's start by looking at the year-to-date price returns (thru 9-30) for some key asset classes:

International Stocks (EFA): -4.59%

Emerging Market Stocks (EEM): -.69%

Commodities (DBC): -9.55%

U.S. Small-Cap Stocks (IWM): -4.71%

Gold (GLD): .22%

Precious Metals (DBP): -3.29%

U.S. Consumer Discretionary (XLY): -.16%

Dow Jones Industrial Average (DIA): 2.77%

S&P 500 (SPY): 6.57%

Some observations:

1) U.S. Consumer Discretionary stocks are companies like Amazon, Nike, Starbucks and Home Depot: companies that tend to lead during market advances. The Consumer Discretionary sector handily outperformed the S&P 500 for six straight years, a streak that appears will end this year.

2) When the global economy is clicking Commodities and Precious Metals tend to perform well as strong economic growth increases demand for these products. Economists who were expecting a pick-up in global economic growth in 2014 have been disappointed and these two asset classes have continued to be poor performers. This is nothing new as both are down from where they were in October 2010!

3) The S&P 500 is the obvious outlier in the listed asset classes. The majority of economically-sensitive asset classes are down in 2014. A major reason for the gains in the S&P 500 is the performance of more defensive sectors like Utilities (XLU) and Healthcare (XLV) both up over 10% year-to-date. Also, a few mega caps such as Apple, Wells Fargo and Johnson & Johnson have been on a tear, gaining over 15%. Mega caps account for a large portion of the S&P 500 return and the performance of a few of these firms has masked underlying weakness in the broader market. 

4) U.S Small caps have had a challenging year, and recent deterioration has occurred in large part due to concerns of rising interest rates, which increases corporate financing costs as well as a rotation from small caps to "safer" large caps. The Wall Street Journal has an article out taking a deeper look at recent developments in this important asset class. This chart shows the breakdown in Small-cap stocks relative to the S&P 500 as well as the strong inflow of money into large-cap funds while small-cap funds have seen outflows accelerate. Also of note: small caps are back to their average historical PE ratio going back to 1994. 

The divergence between large U.S. stocks and more economically sensitive stocks like Small Cap, Consumer Discretionary and Emerging Markets may be nothing more than a temporary event, with a broader market rally to soon follow. However, it is important to closely monitor the market internals and look beyond media headlines.