Energy, financial stocks soar: Oversold bounce or the beginning of a break out?

Energy, financial stocks soar: Oversold bounce or the beginning of a break out?

Market laggards have turned to leaders

September is typically the worst month for stocks, but so far the market is proving history wrong.

Month-to-date, the Dow Jones Industrial Average DJIA, +0.28% has risen 1.6%, the S&P 500 index SPX, +0.03% is up 1.8% and the Nasdaq Composite COMP, -0.04% has advanced 1.6%, but what may be more confidence inspiring are market internals, which show that the September rally is broad based, while investors are turning away from defensive stocks toward cyclical names — a move that could signal confidence about future economic growth.

“A couple of significant and bullish developments happened Monday, as banks turned in their best day of the year, helping financials turn up and outperform,” wrote Mark Newton, chief market technician at Newton Advisors, in a Tuesday note to clients. “Additionally, energy also showed good strength as WTI CLV19, +0.94% and Brent Crude BRN00, +0.88% broke out of their four-month downtrends.”

Energy stocks are up 3.6% week-to-date, while financials have risen 1.3% during Monday and early Tuesday trade, versus a 0.6% decline for the S&P 500 index.

Companies in the energy and financial sectors are sensitive to the business cycle and tend to underperform during periods of economic weakness. Investors may be indicating confidence in future economic growth by taking another look at these stocks, as crude oil CLV19, +0.94% price rise along with bond yields TMUBMUSD10Y, -0.69%.

“The two most beat up sectors in the August pullback (energy and financials) both rebounded hard yesterday, and that’s a potential positive for markets if that cyclical leadership continues,” wrote Tom Essay, president of the Sevens Report, in a Tuesday note.

Another positive sign for the market is the month-to-date moves in the Value Line Geometric index VALUG, +1.18%, which tracks the roughly 1,700 largest public companies in the world, and is calculated to reflect the performance of the typical company in that grouping, whereas other broad indexes like the S&P 500 can be skewed by price moves in a handful its largest components.

The Value Line Geometric is up 3.6% in September, versus the S&P 500’s 1.2% gain.

Jeff Saut, market strategist with Capital Wealth Partners, argued in an interview with MarketWatch that a second measure of market breadth — the ratio of the number of individual stocks rising in value compared to those declining in value — is another positive sign for markets.

“The advance-decline line is a better measure of the stock market than the indices,” he said, adding that the roughly 3/2 ratio of advancing stocks versus declining stocks this week means “the break outs [in energy and financials] are real. I think this market is going substantially higher.”

Several analysts, however, cautioned investors that this rotation would have to last much longer than two trading days before it triggered a clear change in investor sentiment. Others argued that the action so far this week could be bad news for stocks.

Charlie McElligott, head of cross-asset strategy at Nomura said that Monday’s price action should be viewed through the lens of “momentum” stocks, or those that have seen the best price gains over the past year, versus “value” stocks, or those that are cheapest based on price-to-earnings ratios and other valuation metrics.

He said that the decline in momentum stocks of 7.7% on Monday was the second-largest one-day move for that group since 1984, pointing out that the S&P 500 typically falls by 4.2% over the next six months following occasions when momentum stocks have sold off as steeply. That said, it has also typically preceded a whopping 27.1% return for value stocks over the same period.

“The shock of yesterday’s US equities factor reversals will go down in infamy alongside the August 2007 ‘Quant Quake’ and the Fed/March/April 2016 ‘Market-Neutral Unwind’ as one of the more stunning trades in modern market history,” McElligot wrote in a Tuesday commentary.

This would not be the first time during this bull market, however, that analysts cited market internals to call a rotation from fast-growing momentum stocks into inexpensive value stocks, so investors have reason to be cautious.

Michael O’Rourke, chief market strategist at Jones Trading agreed that a rotation into value could be a sign of deteriorating, and not improving, sentiment. “The riskier areas of the market are deflating,” he wrote in a note to clients. “For the time being, the capital is rotating into value and is not exiting the market yet. That said, the change in the market tenor . . . is something worth close monitoring.”

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