The Elfenbein Theory to Explain the Entire Stock Market

I had a little extra time this morning, so I’d thought I’d do a quick post that explains the entire stock market for you.

Before I begin, let me stress that I’m discussing generalities about how the stock market behaves. As you read this, I urge you to focus on the larger themes I’m discussing instead of getting bogged down in nitpicky details or in excessive demands for precision. Out of necessity, my explanation is over-generalized.

The first thing to understand is that the stock market is overwhelmingly influenced by interest rates. It’s difficult to overstate this key fact. More specifically, the stock market is ruled by long-term and short-term interest rates. Of the two, long-term rates are more influential.

A few years ago, I ran some through some historical data. I isolated all the days in which the 10-year Treasury yield closed lower. On those days, the stock market averaged an annualized gain of more than 42%.

The bond market leads the stock market. Whatever the bond market is doing, the stock market will likely do a few weeks or months later. The two assets are in constant battle for investors’ love. Their perpetual tug-of-war is at the heart of financial markets. Short-term rates are also important, and that’s why the Federal Reserve is so closely watched.

The movement of short-term and long-term rates also determines which types of stocks do well. When long-term interest rates rise, cyclical stocks tend to outperform the overall market. When long-term rates fall, defensive stocks tend to lead the market. Importantly, this is a short-term relationship that grows weaker as time wears on.

With short-term rates, we see a similar but slightly different effect. When short-term rates fall, value stocks outperform. When short-term rates rise, growth stocks tend to lead.

These are the two primary “dimensions” of the stock market (Cyclical/Defense, Value/Growth). These categories have some similarities, and they’re easily confused, but I want to highlight their differences. The Cyclical/Defense divide is fought over the future of the production part of the economy. Are we producing more than we’re consuming, or consuming more than we produce? The Value/Growth divide is about the financial part of the economy. How much inflation will there be, and what are real rates doing?

By Cyclical stocks, I mean stocks in sectors like Energy and Materials which are closely tied to the economic cycle. The Defensive sectors are areas such as Consumer Staples and Healthcare, which are areas that aren’t so hurt in downturns.

Value stocks are generally in high-dividend areas like REITs and Utilities. As short-term rates drop, investors naturally crave those dividends. Growth stocks tend to be in low-dividend areas like Tech and more inflation-sensitive sectors like Commodities and Gold Mining.

As I said, these two dimensions are related. They’re cousins in much the same way that short-term and long-term yields are cousins. Now with this background, let’s envision the market as a matrix with short-term rates on the horizontal axis and long-term rates on the vertical.

You can probably see where I’m going with this. We now have four quadrants. The upper right is when both long-term and short-term rates are rising. The lower left is when both ends are falling. The lower right is when short-term rates are rising and long-term rates are falling. In other words, the yield curve is getting narrower. The upper left is the opposite: the yield curve is getting wider.

When long- and short-term rates both rise, industrial stocks do well. When both rates fall, dividend stocks do well (more probably, they’re falling the least). When the yield curve widens, financial stocks do well. Bear in mind that a bank is basically the yield curve with incorporation papers. As the yield curve narrows, defensive stocks do well. Importantly, we’ll also see that when a particular quadrant behaves one way, one of its opposing quadrants will do the exact opposite.

Let me add a clarification. It may be the case that industrial stocks lead the market, not when short-term and long-term rates are literally moving in opposite directions, but when the spread is increasing. What the market is concerned with is the relative standing of short and long rates against each other.

With the four quadrants, the general stock market moves clockwise around the matrix. Quadrant I is the sweet spot of the rally. These stocks have a double-whammy effect: they outperform while the market itself is rallying. Hence the name cyclicals. Conversely, they underperform when the market is tanking (Quadrant III).

I should add that few stocks are pure breeds belonging solely to one quadrant. Typically, they have mixed DNA. For example, a stock like Chevron is a classic energy stock, but it also pays a generous dividend. You’ll also see healthcare stocks, which are classic defensive stocks, that are partly related to tech stocks.

As I mentioned before, these classifications are most important in the short term. As time goes on, the part of any stock which reflects its individual nature will become more prominent. Each day, two biotech stocks may track each other closely, but after five years, they can be miles apart. The more times that passes, the stronger this effect is.

The idea that different sectors do better or worse at different points in the economic cycle is nothing new (see here and here). It’s been pointed out many times before. The Elfenbein Theory, however, is a way for investors to see an overriding framework for what drives this behavior.

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Posted by Eddy Elfenbein on May 19th, 2015 at 8:11 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.