Last week, I quickly discussed the performance in sector funds over the past month. We have new emerging leadership in energy this month while financials take a breather. I wanted to take the time to focus not only on short-term changes, but also show current trends that are still in effect. The idea is to find where you want to start screening for stocks and where you might want to consider trimming.
I still believe the market is overbought based on my technical work as discussed last week. We’re also near a resistance level in the S&P 500 based on the last two previous peaks of April and September of 2012. With that in mind, subtle signs in sector rotation can help us determine if a rotation is taking place towards more conservative stocks and away from pro-growth stocks. Let’s first look at each sector and then make some conclusions based on how they’re trading.
When looking for sector outperformance or underperformance, relative strength analysis (R/S) is a chart tool we can use. The basic idea is to divide that which we want to observe by the market itself. If the series is rising, that means the security (or sector fund in this case) is outperforming the market. If the series is falling, that means the security is underperforming the market.
I want to stress that outperformance and absolute performance are two separate things. You could have something go up on an absolute basis (a rising chart), but it may underperform the market (falling relative strength) because the market’s going up faster. Case in point: healthcare and consumer staples. Many healthcare and consumer staple companies have rising charts, but they may be rising at a slower pace than the rest of the market, and as such, they might have a flat or falling relative strength chart.
After the late spring sell-off last year, there were a number of sectors that had bullish inflections: consumer discretionary stocks and financials. The move was highly correlated to the growing consensus that housing in the U.S. was turning around. That call was bullish for construction materials, homebuilders, home furnishings, and the financials. The S&P/Case-Shiller Home Price Indices turned positive for the first time in years last summer, at just the right time when the market found a bottom.
The strength in those two sectors started to outperform in late 2011, after a quick hiatus mid-summer, they resumed leadership. Here in 2013, that leadership remains thus far. The consumer discretionary sector fund is up 5.67% here as we end January while the financial sector fund is up 6.1%, despite some of the profit-taking in the money centers on earnings.
Looking at the relative strength charts for both the consumer discretionary and the financials, I see that both are rising, and have done so for some time. This is a trend, that doesn’t show any inflection yet; however, I am seeing short-term issues here which indicate to me that there is some profit-taking going on as the S&P 500 sits here at 1500 over the last week in overbought territory.
Consumer Discretionary versus the S&P 500 shows that we may have a short-term top here. The issue is that if the top completes and the Relative Strength falls through the trend, we could be looking at a leadership change here. This is something that should be watched closely.
The financials have been a leading sector for some time. They exploded recently in December, but since earnings began, they’ve been trading more in line with the market. We can see this by a sideways relative strength chart. The trend is still very well developed, and shows no sign of reversing yet.
When China began to bottom in December, it was the catalyst for late-stage cyclicals like industrials and materials. Recently, that has also begun to include energy. Here in the relative strength charts, we can see exactly when these sectors have had bullish inflections and we can determine whether those emerging trends are still intact.
Right about the end of October, we were hearing from Caterpillar, United Technologies, and more that their China business segments were starting to improve. On top of that, energy was at a low, as were the transports. I wrote an article on October 4th near the transport lows discussing there was more than meets the eye when viewing the DJ Transport Index. In addition, we started to see PMI data from China and the U.S. reverse and begin to rise. We’re also seeing that situation in Europe. Since then, the industrials have outperformed the broad market. There has been a short-term correction recently as the S&P 500 has paused near 1500. It’s not surprising because we should begin to see some profit-taking in a market leader with the market near overbought conditions. While the S&P 500 only fell 6 points yesterday, the DJ Transport Index fell 1.5% which is pretty steep considering. It recovered some of that loss today, but looking at the momentum indicators on the Transports, it’s possible we may have a momentum high. That could lead to some churning over the next month before an eventual top on less momentum.
Proving ever the volatile group to trade, materials were a strong winner in December as China’s Shanghai Index climbed more than 15%. But concerns over the Fed’s minutes earlier in January caused traders to reconsider how long QE3 might last. On that note, this week’s GDP figures served to reinvigorate the idea QE3 will be here for a while. I’m sure we’ll even get more noise tomorrow with the jobs data.
If you thought materials were an easy pick on the back of QE, Central Banks are certainly making it difficult to follow the trend with the subtle but very large change in making QE data dependent. As I mentioned last year with this new change, I expect continued volatility in the commodity and basic material sector as traders are struck blindly by converging catalysts at every turn, every week. The long-term trend should be higher based on ECB refunds of Long-term Refinancing Operation (LTRO) while the Federal Reserve is in full QE-mode and China is in full recovery; however, what we may see from the ECB next week is some rhetoric that Europe is getting concerned about a rising euro (which we’ve head recently from Jean-Claude Juncker). Again, this is all to reiterate that volatility should remain in basic materials while the long-term trend is likely higher.
Right now, this is my favorite sector. On an absolute basis, many of the energy services stocks are creating long-term bullish chart patterns with breakouts in many of the service names. Refiners continue to be on a tear, while even the largest-cap names like Exxon and Chevron test their all-time highs. Like materials, the energy sector had a bullish inflection this month based on its performance versus the broad market (S&P 500). We can see that in the chart below.
Energy began to outperform during the summer, but then it went sideways for the rest of the year, essentially falling in to trend with the S&P 500. This month I noticed a shift on a relative basis (chart above) while at the same time, on an absolute basis many companies were forming well-defined bottoms. Better yet, many more have even broken out to all-time highs like Cameron International Corp (CAM) today. Once of the worst performers in 2012, energy is a possible winner in 2013, at least for the first half. The flip side of that coin is that eventually, according to Jim’s petro-dollar cycle, rising energy prices will hurt the consumer’s pocket book where 70% of our GDP comes from. That could curtail energy’s performance to just the first half, but I’m getting way ahead of myself here.
Market Performers and Laggards
Healthcare has been trading in line with the S&P 500 with a sideways R/S chart; however, that may be shifting here as the chart shows a possible bullish inflection point. This just means that healthcare may be returning to a market outperforming mode. Outside of the R/S chart on the sector, many of the companies within healthcare continue to show some great absolute price charts – many of which are still hitting 52-week highs. This is to say, that your portfolio should have healthcare stocks. Here you’ll find great value, great dividends, and great charts. Just be careful in biotech and do your homework.
Staples are pretty much the same story as healthcare, but it’s more of a mixed bag. While there’s been some underperformance in staples since the beginning of December, near-term I want you to note a possible turn here as the S&P has traded sideways in the last week. Staples are starting to turn up, but we still don’t have a major bullish inflection yet like the one that started in April.
Ever since Apple began to top in September, the technology sector has underperformed the S&P 500. I mention Apple because it’s 17.54% of the XLK’s holdings. For a stock that’s dropped more than 30%, that really is going to slant the index. Technology’s underperformance isn’t all due to just Apple, stocks like Microsoft and some of the telecom giants have helped as well. It certainly masks some of the great performance we’re starting to see in semiconductors, which is unfortunate. Overall, this trend of underperformance versus the S&P began in the fall and is continuing through January.
Utilities were a big performer in the first half of last year, but they gave up that outperformance in the second half. The chart today still shows that the trend is down, but halfway through this month, they began to turn up. The S&P 500 has traded sideways and now utilities are turning up. Another week sideways or down and the utilities could have a bullish inflection. Despite the utility sector’s underperformance, there are still many charts in the sector that look terrific. The Financial Repression of low interest rates continues to force investors to find yield in stocks, and in utilities especially.
Sector Rotation is the theory that certain sectors outperform in the various stages of the business cycle. That four-year cycle has contracted to 6-month cycles over the past few years due to the petro-cycle and central bank intervention. That means we’re going through sector outperformance and underperformance at mach speed as I discussed in 2011.
I’ve highlighted the sector outperformers and laggards of late. Judging where we are in the sector rotation road map, we’re near the section where market tops occur. Sector outperformance can last for months (6 on average). I don’t believe that a major market top will take place in February - a short-term top yes, but not a major top. One may have already begun. There are still too many secular catalysts and reasons to stay long stocks through a short-term correction for now, but I promise to track my indicators to mention when this might occur. A major top will probably not occur until later in the first half when oil begins to cause consumers to change their minds about discretionary funds.
I wanted to quickly update my chart from last week as the S&P 500 is possibly leaving the overbought zone on the daily chart. There’s a decent amount of chart resistance here at 1500 based on the previous two peaks. We’ve had a great move already from 1343 and the 50’day moving average is 3.6% below the market from here. But first, retail investors need to stop chasing.
Finally, one last indicator that continues to hammer the point that we’re overbought and the risk of a short-term correction is here is found in the number of advancing issues. The number of advancing issues on the NYSE has declined in the recent advance from 1472 to 1509. This is another diverging sign on top of the number of stocks above the 10-day moving average I showed last week.
About Ryan Puplava CMT
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