Should Recent Sector Performances Spook You Out of the US Market?

The United States’ economy has been firing on all cylinders for a while now, which has led to very strong gains for its major stock indices. These gains include year-to-date returns of 3.5% for the Dow Jones Industrial Average, 4.2% for the S&P 500 Index, and 7.3% for the NASDAQ Composite Index as well as gains of 10% for the Direxion Daily S&P 500 Bull 3X Shares (SPXL) through October 10 (Data source: Yahoo Finance.

While the major indices have been hovering around all-time highs, leading indicators—including semiconductors, financials, and homebuilders—have been showing some weakness, to say the least. The Direxion Daily Semiconductor Bull 3X Shares (SOXL), Direxion Daily Financial Bull 3X Shares (FAS), and Direxion Daily Homebuilders & Supplies Bull 3X Shares (NAIL) have quickly turned from market darlings to market duds, and the pain may only be getting started. Investors could choose to buy the Direxion Daily Semiconductor Bear 3X Shares (SOXS), Direxion Daily Financial Bear 3X Shares (FAZ), or the Direxion Daily Real Estate Bear 3X Shares (DRV) to profit from continued weakness in these leading indicators if they believe the weakness will continue. But also, some investors may start to look overseas for positive returns, as those markets have been particularly beaten up in the wake of trade wars.

Semiconductor stocks were red-hot in 2017 and at the start of 2018, but they have been some of the weakest names in the market over the last three months. The weakness in semiconductor stocks could be attributed to the end of the super cycle, which actually began in late 2017 as NAND pricing came under pressure, and the worries surrounding these stocks have worsened as we apporach 2019.

Why are investors afraid of 2019? Nearly every company in the United States has benefited from the changes in the tax code, but the big boost to earnings growth in 2018 will cause a hangover effect in 2019 as growth rates come down significantly to more normal levels. Plus, experts believe memory pricing could drop 15%–25% in 2019, which means many semiconductor stocks could actually experience negative earnings growth and that the weakness in the industry could get much, much worse. Here is how the SOXL has fared versus SPXL through October 10.

Source: Yahoo Finance. Performance data quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For the most recent month end performance and standardized performance, click here.

Financial stocks are often spotlighted as major beneficiaries of rate increases, but this is a misconception. Gradual rate hikes over long periods are, in fact, good for banks. But a rapid increase in rates in a short period, like our Fed has been doing, has the opposite effect. Why? Because while rising rates mean banks can charge more for loans, they have an adverse effect on the price of fixed-income securities like bonds, which make up the bulk of banks’ assets.

So, yes, banks can charge more for loans going forward, but the value of the fixed-income assets that they have accumulated over the last several years should decline, which would likely lead to a decline in book value. Plus, banks—like most US corporations—will see a hangover effect from this year’s tax cuts and see their earnings growth rates come back down to more normal levels in 2019, setting them up for a pretty rough year if rates continue to rise. Take a look at how financials are faring against the SPXL.

Source: Yahoo Finance. Past performance is not indicative of future results. For standardized performance, click here.