Gone Fishing

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Between September and January, investors take place in a very ritualistic ceremony in which they comb their portfolio looking for losers, and then dump them. There’s a name for this ritual and it is called, tax-loss selling. Sentiment towards these stocks can bottom eventually and support levels form. Eventually, the stock is poised for a recovery as there’s nobody else left to sell.

Before we get into some of the areas that investors have abandoned, let’s discuss sector rotation briefly and the business cycle. Sector rotation theory states that different sectors are stronger at different points in the economic cycle: recession, recovery, full recovery, and early recession. Influences by central banks, Europe, and China have muddied the waters quite a bit over the past three years. Removing stimulus, adding stimulus, and subtracting it yet again have all served to make economists feel we’ve been riding a roller coaster. Now that Europe’s sentiment over its debt load has cooled and the Fed has moved away from a calendar-based target system, the business cycle is beginning to normalize. Here is a chart showing the relationship of sector strength and how it correlates to the peak and trough of a normal business cycle:

sector model

“Skate to where the puck’s going to be, not where it’s been” – Wayne Gretzky

Warren Buffet and Steve Jobs have used Gretzky’s hockey adage and have applied it to investing and business. Using it with sector rotation theory, we can look out to where the market might be 3-6 months or more from now. So where is the puck now?

Currently, the areas of the market that are showing outperformance over the past couple of months have been: Basic Materials, Cyclicals, Industrials, and Healthcare. Energy has been outperforming and leading the S&P 500 in the second half of 2013 if you cross out XOM, CVX, and the refiners from the XLE. Healthcare is a bit of a business cycle anomaly, because normally, it should be underperforming like staples at this stage in the cycle. It’s likely that the biotech stocks (high beta) and the Affordable Care Act are influencing the sector outside of the normal business cycle.

Combining the sectors that are outperforming with the chart above, we get the general idea that we may be in the early recovery portion of the economic cycle and in the bull market stage of the market cycle. This is just about the time that investors finally “accept” the market. By accepting the market, investors begin to move into pro-cyclical companies and they begin to move up the risk curve. When utilization rates begin to top out and materials become scarce, we finally enter the market top stage. With official unemployment above 7%, and that’s being generous, we have a ways to go to get to full utilization of our factories, power generation, and labor force. That’s not even including the level of underemployment as corporations maintain high levels of temporary and part-time employees due to rising benefit costs.

la times
Source: LA Times

Now that we know where the puck has been, where is the puck going to be? Looking at stock performance over the year, it’s pretty easy to spot the kind of stocks I was talking about that have underperformed and have suffered tax-loss selling recently. They’re mostly in the material and mining segment as well as some of the interest-rate sensitive areas like high-dividend stocks, utilities, and housing. Some of those areas have begun to show some bottom-fishing characteristics and appear to be basing. Some stocks within those sectors have even shown positive inflection points. For instance, look at Freeport McMoran (FCX).

fcx

The stock price has been basing for two years and has finally broken the downtrend. Looking at our sector rotation model, it would only make sense that as the economy continues to improve, material pricing should also. Take a look at copper. The commodity looks late in its downtrend and the low for this cycle is probably in. A reversal and positive trend would be bullish for Freeport.

copper

Gold is also showing signs that it may be late in its downtrend. An intermediate-term buy signal was registered recently when the September-October Trend broke this week. If gold can get above 1425, the long-term trend will turn positive for the first time in two years.

gold

So if you’re scared of how much the market has gone up or you’ve missed the run in cyclicals, maybe you want to begin doing some bottom-fishing in materials, energy, and maybe some of those interest-rate-sensitive stocks for a trade. It may be time to bait the hook, pull up your waders, and cast away on some of these unloved and oversold beauties.

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About Ryan Puplava CMT

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