Please CLICK HERE to download the sector allocation report in PDF format.
Market Recap
Despite the market turmoil we experienced in early August, markets managed to climb a wall of worry, gaining 2.3% in a month that historically tends to be weak.
- This past August is a textbook example of a V-shaped recovery.
- Early in the month, the market faced intense selling pressure following a cascade of negative events such as weak NFP data and the unwinding of the Yen carry trade. At one point, the VIX spiked to its 3rd highest level ever recorded, with only the GFC and COVID periods showing worse readings.
- That said, as we noted earlier, we believe the NFP data was distorted due to weather, and the recession fears raised by many sources, including the Sahm Rule, were over-reacted.
- Consequently, as initial jobless claims normalized and retail sales (and retailer earnings) remained strong, markets managed to recapture their losses and climbed on the wall of worry.
- An interesting pattern was that we saw the markets sell off into four major events in August:
- The market sold off into the first jobless claim release following weak NFP data, then rallied sharply as jobless claims showed normalization.
- The market sold off ahead of key inflation releases (PPI & CPI) and then rallied sharply as the data indicated inflation was still on a downward path.
- The market sold off before the Jackson Hole Symposium, and then rally sharply as Fed Chair Powell acknowledged, “the time has come for policy to adjust.”
- The market sold off into NVDA earnings but rallied sharply despite NVDA’s stock price falling post-earnings.
- All of this, in my view, reflects the volatility of investor sentiment, which is understandable given that we are in a time of regime shift—from central bank policy to sector rotation, and so on. August, September, and October have historically been treacherous months for the S&P 500 when the market gains more than 10% in the first half of the year. Seasonality work by Mark also shows that the market tends to be weak during September in election years (with the weakness often being back-loaded).
- However, as inflation continues to weaken, the Fed has also shifted focus to its dual mandate, particularly the labor market. With Powell’s note on policy adjustment, a September rate cut appears certain, as the Fed funds futures market has now priced in a 2/3 chance of a 25-bp cut and a 1/3 chance of a 50-bp cut.
- For the rest of the year, with three FOMCs left, the futures market sees an over 70% chance of 100 or more bps in cuts. To me, the real question is how the FOMC will adjust its policy rate and why. As we noted earlier, “real rates” are now 3x higher than at the 2023 Jackson Hole, with policy rates remaining the same, while core inflation YoY has fallen 160 bps from 4.3% to 2.6%. This suggests that there is significant room for the Fed to cut rates, based solely on the current level of real rates.
- And most importantly, as Tom noted, this transition essentially acts as an implicit “put” on the equity market, as falling asset prices would threaten to weaken labor markets.
Regarding sector performance, August saw the market go through three stages: 1) 7/31 – 8/5: a selloff following rising recession fears and Tokyo Black Monday; 2) 8/5-8/19: a symmetric rebound; and 3) 8/19 – 8/31: the market moving sideways within 2% of the prior high.
- Tech & FANG+ were at the center of sector rotation, declining the most during the early August selloff and rebounding the most. During the final two weeks of August, Tech and FANG+ slightly gave up their gains, while market breadth improved greatly and all other sectors advanced.
- In August, Energy was the only down sector, while all others went up. Interestingly, despite the huge tech rebound, sector leadership was more concentrated on relatively defensive sectors like Consumer Staples (due to strong retail earnings), Real Estate, and Healthcare.
- Style rotation tells a similar story: during the selloff, large and mid-cap value stocks declined less, while during the rebound, growth significantly outperformed value across large, mid, and small-cap universes. During the final range-bound period, we saw style leadership rotate back to value and small-cap.
Sector ratings
For September, the largest change has been Mark Newton’s downgrade of the commodity sectors. Specifically, Mark downgraded Basic Materials from Overweight to Neutral and the Energy sector from Neutral to Underweight.
- Energy: Crude oil has been range-bound over the past two years. In the upcoming election, both candidates have demonstrated strong determination to control inflation, particularly former President Trump, who noted that he would increase output to keep crude oil prices low. The planned output hike from OPEC+ is also likely to keep oil prices low for a while, and demand from China remains weak. Given the downward pressure on crude oil prices, it’s challenging for energy stocks to perform well.
- Basic Materials: On an equal-weighted basis, the sector has made several false breakout attempts over the past two years and has been on a relative downtrend since inflation peaked in June 2022. While precious metals have held up since May, industrial metals have given up their gains year-to-date.
Both Basic Materials and Energy also have recently ranked poorly in our tactical momentum metrics, and Mark’s downgrade confirms this.
With the latest changes, sector ratings between Tom and Mark are now aligned in 9 of the 11 sectors. The only discrepancies are in Discretionary, Energy and Utilities, where Tom remains Overweight for Discretionary and Energy, and Underweight for Utilities, while Mark is Neutral on Discretionary and Utilities, and Underweight on Energy.
Tactical rankings
Tactical sector rankings haven’t changed much. The most significant change has been the improvement in Technology, which moved up from #7 to #3. Changes in the rankings of other sectors were relatively moderate.
- Financials and Communication Services remain the top 2, while Basic Materials and Energy remain among the bottom 3.
- Industrials slipped out of the top 3 to #5, while Discretionary escaped the bottom 3 and advanced to #6.
- Real Estate’s ranking fell into the bottom 3, primarily due to its relatively low DQM and EPS rankings.
Combined Strategic and Tactical Sector Ratings:
- Compared to last month, we have added 2.3% sector allocation to Information Technology—2.0% due to its top 3 ranking within the tactical momentum metrics and 0.3% due to its relative performance in August.
- Discretionary’s recommended weight increased by 1.7% due to its improvement in tactical sector rankings, while recommended weights in Industrials and Real Estate decreased by 2.0%.
- Recommended weights in Financials, Healthcare, Staples, and Utilities are marginally higher due to their relative outperformance in August.
- Due to Mark’s downgrade of the Energy sector, we reduced its weight by 0.2%. We still allocate zero weight to Basic Materials, especially given its poor ranking in tactical metrics and Mark’s latest downgrade.
Compared to the overall S&P 500 index:
We are generally overweight the cyclical and secular growth sectors while underweighting the defensive and commodity sectors.
Currently, we are overweight:
- Technology +2.9%
- Financials +2.5%
- Communication Services +2.0%
- Healthcare +0.6%
- Industrials +0.4%
- Discretionary +0.2%
While underweighting:
- Utilities -0.8%
- Real Estate -1.6%
- Materials -1.9%
- Energy -1.9%
- Staples -2.3%
*The above weights are based on an 85% Sector ETF + 15% Tactical ETF allocation. For a 100% Sector ETF allocation, refer to slide 43 in the attached deck.
Special Note about the SPDR Tech Sector ETF
As we noted in prior publications, SPDR sector ETFs have historically been a good investable vehicle that closely tracks the S&P 500 sector indices.
However, with the rise in NVDA stock price and the concentration of big tech names like MSFT, AAPL, and NVDA, the constituent weight cap rule of the underlying index tracked by the ETF has shown flaws, leading to a major “tracking error” between the Tech Sector ETF and the S&P 500 Technology GICS 1 index. The ETF was heavily underweight NVDA in early 2024 and is now heavily underweight AAPL.
To reduce the “tracking error,” based on our rough calculations, for every $100 invested in the XLK ETF, investors should buy:
- An additional $30.50 in AAPL 0.36%
- An additional $10.50 in MSFT 0.80%
- An additional $10.00 in NVDA 0.70%
- An additional $3.50 in AVGO 0.76%
- An additional $1.50 in ORCL -0.38%
So, the constituent weights within the new $156 portfolio will be closer to those within the GICS 1 sector, reducing the performance discrepancy.
ETF Picks
In August, 2 of our ETF picks, USRT -0.90% and IHAK 0.54% , outperformed the S&P 500, while three of the five picks, KRE, IBB, and PAVE, underperformed.
Despite the underperformance, we decided not to make any changes to our ETF picks:
- Financials, Healthcare, and Industrials performed strongly, especially during the last two weeks of August.
- We have seen a great sign of market broadening, especially following NVDA’s earnings. This breadth improvement supported the market, even though NVDA, one of the largest S&P 500 stocks, declined 7%.
- KRE -1.81% , IBB -0.06% , and even PAVE -0.58% are likely to benefit from this market broadening.
- A special note about IHAK 0.54% : Tom and Dan Ives from Wedbush Securities will hold a webinar and fireside chat this Thursday with the FS Insight family and community. You might remember earlier this year, Tom and Dan had a webinar on technology and cybersecurity. This Thursday, they will share their refreshed views on AI, cybersecurity, and technology in general. Don’t miss it — SIGN UP for the webinar today!
