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S&P 500 Outlook - Are Stock Market Sectors and Factor Exposures Sending a Warning?

S&P 500 Outlook - Are Stock Market Sectors and Factor Exposures Sending a Warning?

Ryan Grace, Chief Market Strategist - tastytrade

Key Talking Points:

  • S&P 500 sector performance and factor exposures are starting to trade as if we’re headed towards a more volatile market environment for stocks.
  • S&P 500 implied volatility has declined from historically elevated levels, but we might not be out of the woods just yet.

The stock market has taken investors on a wild ride over the past couple of weeks, following the emergence of the new COVID Omicron variant and renewed expectations the Federal Reserve will announce an accelerated reduction of asset purchases during its upcoming FOMC meeting on December 15.

Equity market fear, as measured by S&P 500 implied volatility (VIX) has receded recently, but this doesn’t necessarily mean we’re out of the proverbial woods, just yet.

In today’s note, let’s take an updated look at both sectors and factor performance for any hints as to what might be next for stocks. Will investors wish for a year-end “Santa Claus rally” come true, or are there similar signs of pending weakness, as indicated by our S&P 500 Technical & Sector Outlook research piece, prior to September’s sell-off.

Sector Performance

S&P 500 sectors are starting to show signs of more defensive positioning among investors per the outperformance of Utilities (XLU), Tech (XLK), and (Real Estate) on a 1-month basis. This is against a near-term pull-back in Financials (XLF), Energy (XLE), and Communications (XLC); sector exposures that typically exhibit relative outperformance when the economic growth outlook is robust and risk appetite is high.

Now, short-term, this could simply reflect a rebalancing following pro-cyclical strength, post the September COVID-Delta growth scare. And let’s not forget, the bullish trend across sectors is still intact on both a 3- and 6-month timeframe. For example, the energy sector remains strong, rising 20% in the past 3 months, but this recent re-acceleration of defensive sectors warrants attention.

If you recall, the market exhibited similar behavior in August ahead of a bout of volatility. Which we argued reflected cautious positioning, given uncertainty surrounding the trajectory of both economic growth and inflation dynamics at the time. See sector performance table below.

S&P 500 Sector ETF Performance

S&P 500 Outlook - Are Stock Market Sectors and Factor Exposures Sending a Warning?

Factor Exposures

Shifting our attention to equity factor exposures, there are some parallels to our sector analysis.

Factor analysis plays a key role in the process of forecasting markets, since factors are attributes associated with the market performance of a stock, independent of a company’s fundamentals or operating metrics.

Therefore, we can use factor analysis to gain a better understanding of what the market is telling us from a top-down perspective. E.g., during periods of risk aversion, we might see crowding into, and hence the outperformance of stocks with minimal levels of volatility compared to those with higher betas and longer duration growth prospects.

At present, we’re starting to see the exact opposite of what was observed in our mid-October note, “S&P 500 Forecast: Is the Stock Market Signaling an End to the Economic Slowdown?” which preceded a roughly 10% rally in the S&P 500.

Contrary to when pro-cyclical exposures such as small cap, value, and high beta were generating alpha... Now, more defensive or risk averse factors such as low volatility, growth, quality, and high dividend paying stocks are outperforming on a relative basis. Not to mention the re-emergence of the large cap growth over small cap growth/value trade, as seen in the table below.

Factor ETF Relative Performance vs S&P 500

S&P 500 Outlook - Are Stock Market Sectors and Factor Exposures Sending a Warning?

As traders, we know timing is everything and our analysis should extend further beyond sector and factor performance, but if these warning signs continue flashing, I believe we should pay attention.

I’m certainly not calling for an outright market crash but coupled with tighter financial conditions and a Federal Reserve that’s slowly walking back its accommodative monetary policy, it’s likely stocks could experience elevated volatility as we head into 2022.

Resources for Traders

Whether you are a new or experienced trader, we have several resources available to help you; indicator for tracking trader sentiment, quarterly trading forecasts, analytical and educational webinars held daily, trading guides to help you improve trading performance, and one specifically for those who are new to forex.

---Written by Ryan Grace, Chief Market Strategist at tastytrade

You can follow Ryan on Twitter @tastytradeRyan

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.