Investors are understandably jittery as the second quarter gets under way. Recession risk has increased, and persistent inflation is raising the question of whether there could be more rate hikes ahead from the Fed. What's more, news headlines in March about the banking sector sent financial stocks tumbling, bringing back bad memories of 2008 for some investors.
What do these developments mean for the stock market as a whole? I've researched market data around similar events in the past to see what it might say about where stocks could be headed. What I found suggests potential opportunity, especially for more economically sensitive sectors. Here are 5 themes I'm focused on now.
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1. Bank-sector volatility is not necessarily a negative omen
The closure of Silicon Valley Bank (SVB) in early March was the biggest US bank failure since the global financial crisis of 2007 to 2009. As markets absorbed news of the SVB closure, financial stocks plummeted 4% in one day and 8% in a week.
Investors who remember the bank failures and closures of 2008 may worry that history is repeating itself, and that such steep declines might foreshadow deeper economic and market trouble yet to come. But in fact, history shows that the global financial crisis was the exception, not the rule.
On average, stocks have actually posted above-average returns in historical periods following steep sudden declines in financials (excluding the financial crisis). The financial sector has experienced declines of 7% or more in about 1 out of every 50 weeks (or 2% of the time), going back to 1970. If you exclude the global financial crisis, then in the 12 months following those periods, the S&P 500® returned an average of 14%. I think this finding offers reason for cautious optimism as long as you don't think we're in a replay of 2008 (which I don't).
That said, it's important to note that financial stocks themselves haven't fared well after downdrafts like the one we saw in March. Since 1989, after single-day drops of 4% or more (like what we experienced last month), the financial sector has averaged negative returns over the following 12 months.
2. Stock investors are fearful—which could bode well for returns
There are a number of ways to measure the level of fear in the market. One of my preferred measures is stock valuation spreads. This gauges the difference in valuations between the market's cheapest and most expensive stocks—such as, the difference in price-earnings ratios (P/Es) between stocks with the highest and lowest P/Es. When investors are afraid, they tend to rush into the highest-quality companies and out of the lowest-quality ones, pushing up the difference in valuations between the market's priciest and cheapest stocks.
Currently, valuation spreads are in the top 10% of their historical range, suggesting a lot of fear.
Though it may seem counterintuitive, high stock valuation spreads have been a bullish signal in the past, likely because when investors expect the worst, even small improvements can lead to market gains. Since 1990, when valuation spreads have been in their top 10%, the S&P 500 has gained an average of 8% over the next 6 months. That's a significant edge over the index's 4% average 6-month return over all periods.
3. Bond investors are more sanguine (and that could be good)
While stock investors look highly fearful on this measure, bond investors seem less concerned about the outlook.
Just as valuation spreads indicate fear in the stock market, credit spreads—the additional yield a financially weak company pays to borrow money—indicate fear in the bond market. Credit spreads are only a little above their historical average, suggesting bond investors aren't all that worried about the kind of economic trouble that would lead to higher defaults.
Bonds have a reputation as the "smarter" market. In this case, that reputation may be deserved. Historically, the bigger the gap between stock valuation spreads and credit spreads (that is, the bigger the disconnect between high levels of fear in the stock market and lower levels of fear in the bond market) the better the S&P 500's risk-adjusted return has been over the next 6 months.
4. Cyclical sectors may be poised to lead
When investors get worried about the economy, they tend to sell out of more economically sensitive—or cyclical—sectors, like technology, materials, and consumer discretionary. Instead, they tend to favor so-called "defensive" sectors—or ones that aren't especially sensitive to the state of the economy—like utilities, health care, and consumer staples.
The rush into defensive sectors tends to push up their valuations relative to cyclical sectors. This has happened in recent months, making defensives historically expensive relative to cyclicals.
When relative valuations have hit comparable levels in the past, the stock market has tended to advance over the next 12 months. Since 1976, when the valuation difference between defensive and cyclical sectors was in the top 25% of its historical range, as it is now, the S&P 500 advanced over the next 12 months 90% of the time. Cyclical sectors typically outperformed in those periods.
5. Tech could be a sweet spot
Technology is one of those cyclical sectors that has outperformed in similar periods in the past.
Tech has suffered over the past year, largely because of rising interest rates. Now things might be turning around. Bond yields fell massively in March, with the yield on the 2-year Treasury note dropping almost 15%. After comparable yield declines in the past, the tech sector has outperformed the market almost two-thirds of the time over the next 6 months.
Within technology, semiconductors look especially appealing. The industry's price-to-book-value ratio is in the bottom 25% of its historical range. From these price-to-book levels, semiconductor stocks have outperformed the overall market by 15 percentage points over the next 12 months, on average.
To be sure, economic slowdown remains a possibility, and past performance can never guarantee future results. Still, my research suggests reasons to stay positive about the broad market and cyclicals, including technology.