On Friday’s Options Action on CNBC we had JPM’s former market strategist Tom Lee, now of FundStrat, who made a very bullish case for a Q4 rally for a whole host of reasons but none bigger than:
41% of Fund managers trail their benchmark as of 10/1 and historical analysis shows that the worse the underperformance has been, the greater the eventual YE rally
In his research report from Friday morning, he also cited the following reasons for a beta chase into year end:
Down 1% on the first day of 4Q has been followed by gains into quarter end 92% of the time (average gain 7%) similar to 2009/2011
The Russell 2000 has trailed the S&P500 over the past 6 months by 1,050bp—the worst since 2000. This is not a sign of a market top (only 2 out of 9 prior instances were tops) but curiously seems to signal broader gains ahead
That all makes sense to me, but for the most part it ignores what appears to be decelerating growth in most emerging markets and Europe, and the mounting headwinds of a very strong dollar at a time when the Fed is all but finished QE.
With Q3 earnings upon us, we will get a sense very soon of the impact of recent strength in the dollar. I suspect we will likely see any negative effects in forward guidance as opposed to Q3 results, as the US Dollar Index (DXY) saw the bulk of its recent gains in the last month of Q3:
It would be foolish to disregard Lee’s seasonal argument, largely a function of under-performance by a large part of the investment community. It is our view, the higher we go in Q4 the greater the potential give back early in 2015, much like the Jan/Feb sell off early this year that saw the largest peak to trough drawdown so far in 2014, 6%:
So what to buy into year end? I suspect you want to stay away from the once high fliers that have failed to take flight since (3d stocks, some internet services like Pandora, Priceline, YELP and Zillow, and anything related to precious metals). On Friday we put on a couple trades, one in Nov and the other in Jan, playing for an oversold bounce in large oil stocks, (read here). We believe a further rally based on the notion that the U.S. economy will help lift the malaise in the rest of the world could result in greater demand for oil.
Aside from that, we would want to avoid high yielding sectors like XLU, IYR and HYG, as we suspect a Q4 rally based on greater confidence in our economic recovery should result in higher rates (we have a defined risk short in XLU here).
What about the financials? While the bull case has been anticipating higher rates for some time, the sector has actually performed well even as rates have remained low. The XLF looks pretty healthy holding $22 on the downside:
The strength in financials has generally been confined to large-cap banks and insurance stocks, while smaller regional banks have struggled. A move higher in rates would likely be needed to spur a catch-up trade in the regionals.
The year-to-date performance shows the large dispersion among sectors:
Health care remains the big leader, and is still in a long-term secular bull. If the S&P 500 index does rally into year end, our hunch is that the laggards could be in line to catch up as fund managers buy some of the underperforming cyclical stocks for more exposure. On the flip side, utilities could be in store for some selling on such a rally as investors peel out of defensive exposure, especially if rates move higher in tandem.