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At 2018 Outset: Cyclicals, Transports and Showdown Politics

January 30, 2018
Cycle racers: transports, cyclicals, showdown
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Despite some political fireworks, markets stayed on a roll in January with emerging markets leading the way. Cyclical stocks, transports, and small-caps also lit up the leader board. Healthy corporate earnings, a new corporation-friendly U.S. tax law, and light volatility all helped set the stage for new highs across the major indices. The month also saw rising bond yields and many U.S. bond sectors dipped into negative territory. A short U.S. government shutdown couldn’t dim the lights too much.

New Year's Rally Here and Abroad 

By late January, the benchmark S&P 500 Index (SPX) was already up more than 6% year-to-date and on track for its best start to a new year since 1997, climbing well above 2,800. The Dow Jones Industrial Average ($DJI) tore through two milestones — 25,000 and 26,000 — within the year’s first few weeks. Even the Russell 2000 (RUT) index of small-cap stocks, a laggard in 2017, was setting new all-time highs.

“Pretty much no one probably expected the markets to rally this much so soon in the year, but the positive sentiment isn’t too surprising considering all the bullish news,” said JJ Kinahan, Chief Market Strategist, TD Ameritrade. “Economic indicators continue to look good and holiday shopping looked pretty robust.”

Certain sectors that tend to post big numbers when the economy heats up helped lead gains, helping reinforce feelings that this rally might be based on underlying economic factors and not simply on bullish investor sentiment. The outlying question, however, is whether election year politics, which arguably helped lead to the shutdown, might continue to pop up and cause confusion or create anxiety.

Year-to-date sector leaders include consumer discretionary (up 8% through late January), energy (up 8%), and info tech (up nearly 8%). Also, the Dow Jones Transportation Average, sometimes seen as a derivative of the broader economy, was up a healthy 6.6%, slightly better than the SPX.

Meanwhile, market laggards included utilities and telecom, both so-called “defensive” sectors where investors tend to flee when the economy looks less robust. At the moment, investors appear to want more exposure to sectors that perform well in an advancing economy.

That applies overseas as well. Foreign markets provided some tailwinds for the U.S. so far this year, with Japan’s Nikkei and the German DAX indices posting vigorous gains. Some analysts say that Europe, in particular, might have a longer runway than the U.S. because its economic recovery began a little later, and European stock performance generally trailed U.S. performance last year. Meanwhile, there’s no sign of any slowdown in China, where the Shanghai Composite Index advanced more than 7% in the year’s first three weeks amid better than expected economic growth for the world’s largest country in both Q4 and 2017.

The Tax-Cut Effect

Back home, some of the bullish sentiment stemmed from expectations for a strong earnings season. Though analysts had already expected double-digit earnings gains going into the quarter, the passage late last year of U.S. tax reform might provide an extra boost. Many companies are handing out bonuses while promising billions of dollars of new investments thanks to the tax legislation.

Company guidance for tax rates now averages around 19%, vs. closer to 29% previously, according to research firm CFRA. That could be playing into the upward 2018 earnings revisions some companies have made, and also into fast-rising expectations for full-year 2018 earnings. About 80% of SPX companies had beaten Wall Street’s earnings expectations going into the third week of earnings season, according to Thomson Reuters data.

Tax legislation also could be boosting the Russell 2000, which lagged the broader markets last year. It rose more than 4.5% in the early going of 2018, nipping at the heels of the SPX.

“A lot of the gains in small caps could be related to the tax cut, which might help smaller companies more than larger ones since more of their sales tend to be domestic,” Kinahan said.

Gains on the Job Front

Job data also looked positive early this year, for the most part. The December jobs report wasn’t necessarily a blowout, but it was generally pretty good. In fact, one could argue that some of the numbers, particularly the 0.3% wage growth, fell into what might be called the “Goldilocks” range. That means they were strong enough to reflect some economic gains that could help consumers, but not so strong that they would necessarily alarm the Fed, which continues to project three rate hikes this year.

“The jobs created in December were ‘career-type’ jobs in places like construction and manufacturing,” Kinahan said. “This could be a sign that the economy continues to head in the right direction.”

Beyond the Horizon

What could trip things up in months to come? One possibility is rising Treasury bonds yields, which recently climbed to their highest levels since 2014 and tend to increase borrowing costs. There’s also concern about possible worsening trade relations between the U.S. and China, climbing energy costs, and geopolitical hot spots like North Korea. Politics in Washington, D.C., might also continue to nag, especially since the government faces another budget deadline in early February. Some people might get nervous about historically high price-to-earnings ratios (market value per share/earnings per share).

That said, there continues to be a “buy the dip” mentality on Wall Street, Kinahan said, and that could keep any downticks from growing too steep in the near term.

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