Sector Rotation at Mach Speed

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Today’s market observation will be less on what’s happening at this very moment, or much less this week, but on this year in review. I wanted to look at sector rotation throughout 2011 to review where we are in the model, but also to determine where outperformance might occur in the next few months. The basic idea behind sector rotation is that certain groups in the market outperform at different times in the business cycle, depending on where the business cycle is at. Typically, the average cycle lasts 4 years from early recovery to late contraction; however, each of the nine S&P 500 sectors have actually had their period of outperformance compressed into this year already, and the speed at which the market has shifted weighting from sector to sector has been at mach speed.

The Sector Rotation Model

The chart below shows the order in which sectors perform from boom to bust. In reality there are two cycles: the market cycle and the economic cycle. Market participants invest ahead of actual change in anticipation of a market correction or recovery. As such, the market cycle precedes the economic cycle. Case in point: the stock market has fallen nearly 20% from the highs while the Gross Domestic Product of the U.S. is still in positive territory! That’s because investors are liquidating now in anticipation we are heading into a recession.

sector rotation

Evidence of Sector Rotation

Looking back in 2011, it is fairly clear that we have moved through the sector rotation model at mach speed. Let’s take a step by step look from January to date to identify the transitions. In January and February, the stock market was hitting fresh new highs. Participation (breadth) was fantastic with nearly 90% of the stocks with the S&P 500 trading above their respective 200-day moving averages. The chart below divides each sector by the S&P 500. Anything above the 0 line is “outperforming”. Anything below the line is “underperforming” the S&P 500. In the performance chart for January, technology, industrials, and energy were outperforming. This indicates we were in the “Bull Market” category of the sector rotation model (see above).

performance 1
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The “Arab Spring” takes hold as inflation pressures and low unemployment cause unrest in the middle east. The youth take to the streets and stir uprising that cause oil prices to spike. This set the stage for high inflation pressure (which was already building on the back of QE 2.0) that would help put a chink in the armor of economic growth, but in the short-term caused speculation to run in the “inflation trade” with silver and oil as the main beneficial recipients.

performance 2
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After the Arab Spring heats up oil and commodity prices, a black swan event befalls Japan – a record earthquake that is followed up by a tsunami, a massive power outage, and a nuclear crisis. Behind such an event, leading economic indicators roll over to mark the peak in the economy and the beginnings of a market correction. As such, investors began to shift into defensive investments. This period marked the beginning of Treasury, consumer staples, and healthcare outperformance. Another group was also making a move into outperformance at the time: utilities. I don’t recall hearing any research or newsletters recommending utilities back in April. It was a fairly stealth move by utilities.

performance 3
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In July, the earnings season kicked off and investors bid up prices in advance. Earnings (looking backwards) were good from a lot of players, especially in big technology stocks and other “risk on” investments. The Nasdaq’s move to test its highs came on the back of three major players. Google, Microsoft, and Apple explained nearly 45% of the month’s gains in late June to mid-July. I believe the whole event was an outlier for the sector rotation model due to earnings as those earnings quickly gave way as sovereign debt concerns finally broke the back of the bulls.

performance 4
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This leads us to the current performance period between late July and now. The correction in stocks has been fierce. Deleveraging has affected every area of the stock market, but less so for utilities, consumer staples, and health care. These are defensive sectors in nature. According to the sector rotation model, they are the sectors that outperform in a bear market and early recession.

performance 5
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Conclusion

If you don’t follow economic indicators, market headlines, or company earnings and you just watched how the market rhymes and reasons, then the sector rotation model is telling us that we are in a bear market and early recession. The key to listening to the sector rotation model isn’t so much of what is doing well now, but what WILL do well later. The next sector to outperform is financials. Interestingly, we’ve had a number of catalysts for the group as follows:

  • Analyst recommending financials this week including Richard Bove yesterday
  • Berkshire Hathaway’s news bomb this morning to invest $5 Billion in Bank of America
  • Obama administration protecting the banks? See article
  • Low interest rates until 2013! Bernanke put helps capital intensive sectors like utilities and financials

Shorting pressures were hitting financials pretty hard two weeks ago. They bounced back with energy as the shorts ran for the hills last week. It stands to be a very volatile sector to watch, but one that Warren Buffet feels comfortable investing in today.

Normally, we see sector outperformance lasting near 6 months. This year, it’s happening at mach speed from one month to the next, almost. It appears that consumer staples, health care, and utilities have firmly held the seat of outperformance since March when the Leading economic indicators began to roll over due to high cost inflation and supply issues from Japan.  Long-term, they’re likely to remain there as we go through the process of a bear market. A dead cat bounce may shift them to the sidelines for the intermediate-term, but their outperformance trend is likely to hold out a while longer.

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About Ryan Puplava CMT

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