By Amrith Ramkumar on Morningstar
Banks and smaller companies that were among the market's laggards last quarter have helped stocks to their best January in 30 years, a sign investors are favoring sectors tied to the U.S. economy.
Thursday, despite a modest performance from U.S. indexes, the Dow Jones Industrial Average and the S&P 500 both closed the month with their biggest gains since the 1980s. The industrial average's 7.2% rise was its best January performance since 1989, while the S&P's 7.9% advance was its best start to a year since 1987.
Through Wednesday, the KBW Nasdaq Bank Index had risen 14% this month, on track for its best-ever start to a year. Meanwhile, the Russell 2000 index of small-capitalization companies -- many of which are domestically focused -- was heading for its best January since 1987, with a 10% advance.
The reversal shows that investors who were bracing for a sharp slowdown in U.S. economic activity have been soothed by cautious comments from the Federal Reserve, signs of strength in the labor market and data pointing to tepid inflation.
Although lukewarm economic activity in Europe and China has clouded the outlook for global growth and hurt multinational corporations reliant on trade flows, companies from banks to industrial firms have said U.S. consumer demand remains resilient.
"Our view is through our customers, and this strongly supports a solid growth view," Bank of America Corp. Chief Executive Brian Moynihan said on the company's Jan. 16 earnings call.
Shares of Bank of America have climbed about 15% this month. Citigroup Inc. and Goldman Sachs Group Inc. are up roughly 20% for January, as are some regional banks such as SunTrust Banks Inc. Those surges have helped lift both the Dow Jones Industrial Average and S&P 500. The benchmarks were on pace for their largest monthly advances since October 2015.
Banks were among the worst performers during last quarter's stock rout, but remarks from central-bank officials about remaining patient in raising interest rates have fueled the turnaround.
"The flexibility that the Fed has telegraphed buys us a little more time to perhaps prolong this cycle," said Wasif Latif, head of global multiasset investing at USAA Asset Management. "This is more a reaction to interest-rate policy as opposed to economic data clearing the path for the market. That's still up in the air."
To be sure, indicators used by investors to monitor the strength of the domestic economy have also stabilized. That has helped to spur the rally in small-cap companies, which are more concentrated in the financial, industrial and energy sectors.
The gap between short- and long-term Treasury yields, known as the yield curve, has widened from its December lows, indicating investors feel more confident about the economic outlook. A steepening yield curve also tends to support financial stocks because banks often borrow money on shorter time horizons and lend with longer time frames.
Additionally, commodities including oil have recovered, cooling worries that materials vital to the transportation and manufacturing industries were signaling an immediate slowdown in U.S. demand. U.S. crude-oil prices are still nearly 30% below October's multiyear highs. But they have risen back above the $50-a-barrel level that some analysts say signals sufficient demand, yet haven't climbed high enough for investors to fear a surge in inflation.
And the Citigroup economic surprise index for the U.S. -- a measure of whether economic data are in aggregate exceeding expectations -- recently turned positive for the first time in two months.
Even though investors will see U.S. earnings and economic-growth rates slow, "they are still going to be largely positive and supportive of equity returns," said Cliff Hodge, director of investments for Cornerstone Wealth. "The consumer is in a really strong position."
Analysts also say the temporary resolution to the partial government shutdown and recent stock-market rally should help measures of consumer confidence rebound. They are looking ahead to Friday's jobs report for the latest signals on the economy, as some remain concerned that continued wage growth, a measure of inflation, could give the Fed more leeway to keep steadily increasing interest rates.
Some investors had feared higher borrowing costs would threaten corporate profits, but companies in the S&P 500 have so far reported a stronger-than-expected 12% jump in fourth-quarter earnings from a year earlier, FactSet data show. Although that clip is expected to fall this year, small-cap companies are still projected to post double-digit profit gains throughout 2019.
Even larger manufacturers hurt by trade tensions have said U.S. demand is still steady. Shares of Whirlpool Corp. rose 9.7% Tuesday, their biggest one-day percentage gain since October 2013, after the appliance maker reported that price increases offset raw-materials costs last quarter. North American results were particularly positive in terms of pricing, Chief Executive Marc Bitzer said on the company's earnings call.
"We were kitchen-sinking every possible worst-case scenario going into the end of the year," said Amanda Agati, co-chief investment strategist at PNC Financial Services Group. "Now, we're seeing the results come out and saying, 'Oh, that's not quite as bad as we thought.'"
Still, some analysts expect weakness overseas to hurt the U.S. economy moving forward, particularly if trade negotiations don't yield progress.
Companies more reliant on Chinese consumption of materials and products, including Apple Inc., continue to lag behind the broader market. Shares of the iPhone maker have eked out a 4.8% rise this month, rallying Wednesday even though it posted its first holiday-quarter decline in revenue and profit in more than a decade. Analysts cited low expectations before the report and optimistic comments from CEO Tim Cook on the company's earnings call.
"We are quite concerned about the slowdown in the global economy," said David Kelly, chief global strategist at J.P. Morgan Asset Management. "There's a lot of uncertainty, and that's slowing everything down."