Sector Rotation: Are You Ready for This?

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Shift Happens. More so in the last two years, sector rotation is happening on a very short time horizon as the market sways and swells from economic fears, to policy response. Since the jobs data last Friday, cyclical industry groups are showing renewed strength as portfolio managers rotate into energy, industrials, and materials – late stage cyclicals. These are also the groups that typically perform well on QE speculation and implementation. Recall the top sectors in the second half of 2010 when the Federal Reserve started buying Treasuries under QE 2.0? They were the same as the groups performing well this week. Sector shift is happening, right before our very eyes.

The April FOMC minutes released in May set the ball in motion as more Fed governors moved into the accommodation camp in the April meeting. This was seen as an incremental shift in the opposite direction of policy and gold jumped on the news a day after it had hit new lows this year. Then, the June 1st payrolls data confirmed what many were thinking: the U.S. was slowing and we’re going to need more stimulus. Gold closed at $1,626 from $1,568 the previous day, the biggest 1-day rise in three years. We’ve had FOMC minutes, meetings, and Fed Governor speeches from then that have all continued to hint at easing in our near future, but nothing has been as grabbing as Bullard’s paper in July of 2010 – except maybe Draghi’s mention of outright QE at the last ECB meeting last week.

Here’s the problem: if everybody else eases while the U.S. stays pat, then that would create a catalyst for a stronger dollar. If we know anything about currency wars over the past 10 years, it’s that this would be a bad catalyst for U.S. exports, the euro, and risk assets due to a widening policy gap between the U.S. and the world (everybody else is easing). Perception is everything in the markets.

The focus in the markets right now is on the ECB and the FOMC. Words from Draghi on July 26th that were perceived as a not-so-subtle shift in policy took precedent over the earnings season and economics data. The euro rallied strongly because perception is beginning to change that the ECB will step in and assist in the bond market. Mario Draghi of the ECB is ready to do “whatever it takes to preserve the euro…and believe me, it will be enough” and paraphrasing his other line, to the extent high sovereign yields are hindering ECB monetary policy, the ECB can act (to influence yields) and it would still be within their mandate. The ECB is not supposed to be a lender to sovereign governments. That’s why they’ve tried doing everything they can to stay away from outright purchases; however, as the sovereign debt contagion is spreading to Spain and Italy, the ECB can’t sit idly by as Draghi says high yields are “unacceptable”. As Europe lacks the political will to enforce any more austerity measures, the drums will beat for QE. It’s inflate or die time for the EU and the euro.

So the two reasons the U.S. will also implement QE, is that 1) we don’t have the jobs growth necessary to sustain long-term economic growth and 2) because we don’t need a stronger dollar. The FOMC isn’t the optimal tool in the shed to get the economy functioning better long-term. Nor is it the answer, but it is in our situation with the current gridlock in Congress. As Democratic Senator Chuck Schumer said to Bernanke on the 17th of July:

“I agree with you, under current conditions fiscal policy should be our first choice. It would be more effective. Unfortunately, we can talk all we want. Everyone gives speeches how fiscal policy should be the way to go and we don't do anything. We have had a hard time getting the cooperation necessary to get anything done on the fiscal side…

We know the reality. Can't do it if it is not bipartisan. Given the political realities, Mr. Chairman, particularly in this election year, I am afraid the fed is the only game in town and I would urge you to take whatever actions you think would be most helpful in supporting a stronger economic recovery.”

The Fed is the only game in town. The Fiscal Cliff will be an issue heading into the 4th quarter and in 2013, but here we have an opportunity to make another QE trade. Since the jobs data last week, I’m starting to see the proper performance shift in equities, the dollar, yields, and commodities that corresponds to such a move.

Risk Off Trade Is Off For Now

usd 8 aug 2012
Source: Stockcharts.com

tlt 9 aug 2012
Source: Stockcharts.com

Up until last week, the defensive sectors in staples, healthcare, and utilities were the performers during the rally in the S&P 500 (a whippy one at that). Last week’s jobless claims and payrolls were enough to stay any deflationary worries, but not enough growth that QE is off the table. We have to remember too that a lot of the job creation in the last few weeks is seasonal as well. Regardless of what I think or what readers think about the economic data, investors are shifting their resources out of defensive sectors and into cyclical sectors for the first time in months. Bottom fishing is happening in coal stocks, basic metals, energy services, machinery, and precious metals. Do I think this is the beginning of a new secular bull market in cyclical stocks? No. Is this going to propel the S&P 500 to 1500? Possibly. What I know is that this is a shift that’s happening now and it’s a good sign for the summer rally and weeks ahead.

Sector Performance Relative to S&P 500

s&p sector etfs 26 apr 2010 to 9 aug 2012
Source: Stockcharts.com

Sectors have come in and out of favor on very short time horizons. It is important in this environment to remain nimble. Not many investors are prepared for this kind of rotation and I want our readers to be aware of it. Up ahead, Mario Draghi has promised details about the ECB’s plan to assist in the sovereign bond market. In addition, we have the Fed’s Jackson Hole meeting on the 31st. Then we get the ECB and FOMC policy meetings in September where anticipation is building for a possible rate cut from the ECB and initiation of some form of QE from the two central banks. Merely the possibility of policy shift could keep shorts at bay and hold a bid below equities in the weeks ahead as it has despite high sovereign yields and deteriorating economic data this summer. This also doesn’t mean we jump another 12% in the S&P 500. Understand that the current performance ytd in the S&P has been defensive areas. We could easily see the S&P 500 hold below 1422 while money rotates out of defensives and into cyclicals. The S&P 500 could run in place, but if you’re nimble, there’s an opportunity here at our feet. That’s just my market observation.

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About Ryan Puplava CMT

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