US stocks lost ground in the third quarter—giving back a portion of the gains they'd notched in the first half of the year.
The decline was in no small part due to worries over interest rates. More than a year and a half into the Fed's current rate-hiking cycle, many investors are concerned that interest rates might rise higher than previously anticipated, and remain at high levels for longer than previously expected.
My research focuses on analyzing market history to uncover patterns and probabilities that can help inform the current outlook. Often, these historical patterns serve to challenge the prevailing narrative driving the market.
Recently, my research has suggested that investors may be focusing too much on the negative impacts of higher rates, while ignoring the positive potential impacts of rising economic growth. My research has also been turning up bullish signals on cyclical sectors—but bearish signals on one sector in particular. Here's more on 3 key themes I've been seeing.
1. US stocks: Overlooked potential for strength
It's no secret that interest rates are on the rise. With the economy showing surprising resilience, the Federal Reserve has signaled it may need to hike rates further, and keep them at high levels for longer, in order to keep reining in inflation. This has many investors worrying about the impacts of high rates on the stock market.
But my analysis suggests these investors may be focusing too much on the negatives from higher rates and overlooking the positives from an improving economy. Higher interest rates are often a function of strong economic growth. On a year-over-year inflation-adjusted basis, US gross domestic product (GDP) expanded at a rate of 2.4% in the second quarter of this year, accelerating from 1.7% in the previous quarter. And better-than-expected job growth and retail sales in the third quarter indicated that strength may have continued.
Historically, the strength of the economy has had a greater influence on stock returns than the direction of interest rates. I looked at 12-month periods when economic growth accelerated and interest rates rose since 1962. (I measured economic growth using inflation-adjusted GDP.) Stocks returned an average of 12% during those strengthening-economy, rising-rate periods. By contrast, during 12-month periods when the economy slowed, stocks advanced just 6% when rates fell and 1% when they rose.
The upshot: For investors, an improving economy has historically been a bigger deal than the direction of interest rates.
2. Cyclical sectors: Riding a rotation
An improving economy could also give a potential boost to cyclical sectors, at least on a relative basis. This group of sectors is generally considered to include communication services, consumer discretionary, energy, financials, industrials, materials, real estate, and technology. Since 1962, cyclical sectors have tended to outperform during periods of above-average GDP growth, regardless of whether interest rates rose or fell. Conversely, during historical periods of weak growth, cyclicals have generally lagged defensive sectors (which include consumer staples, health care, and utilities).
A rotation away from defensives and toward cyclical stocks is already well underway. In the 6 months through July, cyclicals experienced relative outperformance that was in the top 5% of all 6-month periods going back to 1962.
Rotations of this scale are generally only seen during recoveries from recessions—and when they've occurred, they've had staying power. Over the last 60 years, the bigger the rotation into cyclicals, the more likely it was to continue over the next 6 months and the stronger cyclicals' subsequent relative performance, on average.
In historical periods similar to what we've just seen—with cyclical outperformance reaching the top 5% of all 6-month periods—the sectors outperformed the market by nearly 6 percentage points over the following 6 months.
3. Energy: One cyclical sector to approach with caution
While I'm seeing bullish signals for cyclical sectors as a whole, there's one cyclical sector that I'd suggest caution on, and that's energy.
This might come as a surprise given the run-up in oil prices we've seen in the past few months. But I'm concerned about a sharp rise in the energy sector's ratio of capital expenditures (CapEx) to sales. (CapEx is the money a company uses to buy, maintain, and improve assets such as land, buildings, vehicles, and equipment. In the energy sector, CapEx includes much of the costs of producing oil and gas, such as for drilling a well.)
Historically, sharp rises in the ratio of CapEx-to-sales have tended to go hand in hand with underperformance (this has been true historically even when the ratio is rising off low levels, as it recently has been). The dynamics behind the recent increase may also be a bearish signal for the sector. The ratio has risen because both capital expenditures and sales fell, but sales fell more. In historical periods with similar dynamics, the sector went on to underperform the market by an average of 9.4 percentage points over the next 12 months.
To be sure, past performance is never a guarantee of future results. But as the final quarter of 2023 gets underway, I suggest investors remember that trends in interest rates and oil prices are only pieces of the current economic puzzle—not the full picture.
Historically, an accelerating economy tends to benefit the market and cyclical sectors—even in the face of higher interest rates. And while higher oil prices might be (all else equal) a positive for energy, other factors might have more influence on the sector's near-to-intermediate-term performance.