Sectors

Yesterday's Weekly Report showed a table of sector operating margins relative to their long-term average, as well as price/sales ratios. Expensive sectors with above average margins appear particularly vulnerable in an environment where overall margins are being squeezed and economic risks are mounting. The consumer discretionary sector stands out as having significant profit margin and valuation downside. The policy backdrop is also turning more hostile. History shows that this sector outperforms when interest rates are falling and/or low, and underperforms when they climb and credit becomes more restrictive. This correlation is evident in the correlation between relative performance and money supply. When the cost of credit is low and liquidity is plentiful, investors discount increased discretionary consumer spending, particularly on durables, and bid stocks up accordingly. The opposite is also true. Currently, money growth is plunging, although remains in positive territory for the time being, suggesting that credit creation is slowing. Importantly, the longer that financial markets stay turbulent, the greater the upward pressure on the personal savings rate and likelihood that discretionary spending is reined in. Even then, a consumption contraction is not a prerequisite for consumer discretionary underperformance. With the Fed determined to keep pushing up interest rates, the macro backdrop is bearish for discretionary stocks. Consumer Discretionary: Fraught With Risk Consumer Discretionary: Fraught With Risk

Equity selloff alone will not catch the Fed's eye unless there is an outright crash.

An oversold bounce may be getting underway, but without a policy assist, it would be a rally to sell. Go to neutral in the growth vs. value trade and beware sub-surface weakness in the consumer discretionary sector.

The previous Insight showed that S&P pharmaceutical index outperformance is well supported by both endogenous and exogenous forces. The same is not true for the riskier biotech space. As discussed in previous research, biotech stocks have exhibited all of the characteristics of a mania. Now the forces that propelled the group higher are working in reverse. Speculation is rapidly being reined in, warning that the flows into biotech stocks are drying up. Margin debt has crested, reinforcing that the high-octane fuel to support momentum stocks is starting to evaporate. Biotech IPOs are going from feast to famine: if share prices continue to fall, expected returns will follow suit, warning against expecting further capital inflows. Consequently, we expect biotech stocks to remain on the mania track, which has not entered the bubble-bursting phase (top panel). (Part II) Pharmaceuticals And Biotech Are Parting Ways (Part II) Pharmaceuticals And Biotech Are Parting Ways

Pharmaceutical stocks have broken from their correlation with biotech stocks, and we expected this divergence to be sustained. Pharmaceutical profits remain one of the few bright spots within the corporate sector. Drug demand continues to boom, as measured by consumer spending data. Inventories have moved higher at both the wholesale and manufacturing level, but this appears to reflect demand-driven stocking of product, given ongoing strong pricing power gains. In a deflationary world, the ability to significantly lift selling prices warrants a premium valuation. Yet the S&P pharmaceuticals index still trades at a large discount to its historic average relative valuation. If domestic economic disappointment mounts, as we expect, it will provide another catalyst for a relative performance re-rating. Stay overweight the S&P pharmaceuticals index. Importantly, it will be important to differentiate pharma from biotech, please see the next Insight. (Part I) Pharmaceuticals And Biotech Are Parting Ways (Part I) Pharmaceuticals And Biotech Are Parting Ways