July 12, 2010

Sector Rotation Model

(Click to enlarge the graphic).

US domestic equity has had a rough two months - are there any winners, or it a matter of losing less?

The daily bar charts above plot the 9 Select Sector SPDR ETFs against the S&P 500. Beneath each chart, in the indicator area, is a relative strength plot between the individual SPDR and the S&P500 SPDR ETF (SPY, black bars). Black dashed vertical lines denote a peak in SPY on 26 Apr 10, and individual dashed vertical lines denote relative strength peaks of interest. The colors correspond to the following, top to bottom in each column, left to right:

1. Top left: Consumer Discretionary (XLY, royal blue)
2. Middle left: Technology (XLK, navy blue)
3. Bottom left: Industrials (XLI, grey)
4. Top center: Materials (XLB, brown)
5. Middle center: Energy (XLE, red)
6. Bottom center: Consumer Staples (XLP, purple)
7. Top right: Health Care (XLV, magenta)
8. Middle right: Utilities (XLU, teal)
9. Bottom right: Financials (XLF, green)

Sector rotation theory generally tells us that, under normal circumstances, most market ascents are led first by a bottom in Financials, followed shortly by a rise in Consumer Discretionary and Technology. Eventually, Industrials and Materials get in on the action, and Energy begins to rise. Many have argued that Energy leads at the top, and a subsequent defensive play leads to moves into Consumer Staples, Health Care and Utilities. When the market is ready to rise again, the cycle repeats.

The events of the last 24 months have been anything but normal. Massive declines in Financials have largely upset this model, whereby bounces off extremes in Financials selling have caused periods of generally greater relative strength in this sector ahead of the S&P 500. This had left many, including myself, to ponder what sector could best described a leading indicator of health in the market. The answer, unfortunately, has been difficult to come by.

Some observations can be drawn, however. Major winners in the recovery off Mar 09 equity lows have been Consumer Discretionary and Technology. There have been periods of other winning growth, some of which is seen on this chart in the form of Industrials. With the market having been in decline, and now seemingly attempting a counter-trend rally, we turn our attention to plays from this calendar year. To wit:

1. Consumer Discretionary rose higher than equity into 26 Apr 10 highs. From that point forward, it traded at near parity with equity until the late May 10 bounce. Since then, this sector has been an underperformer and investors appear to be losing their appetite.
2. Technology really appears to be the drum to which the market is currently bouncing, or vice-versa at the least. While one could argue a minor peak occurred in Jun 10, the sector appears largely to be moving in sync.
3. Industrials were a winner for practically the entire first half of CY 10. Coming out of the flash crash, we've seen some waning in the sector leading us to conclude the sector is falling out of favor - all be it less severely than Consumer Discretionary.
4. Materials are similar to Industrials, but the effect is largely muted. While there was a modest rise in the first have of CY 10, this came off a steep sell off in Jan 10 (barely seen on the left of the chart). Despite the recent few day surge, Materials appear out of favor.
5. Energy has been in decline cross much of this time period. Perhaps the best we can say about Energy is that the entire complex appears to have failed to gather any interest among investors, and is not likely to be in favor going forward.
6. Consumer Staples - the first of our defensive plays - tells a strong story. This sector led the charge to start out CY 10, but that enthusiasm waned until the market peaked in Apr 10. Since then, we're seeing a strong move into Consumer Staples and is taken as a defensive posture.
7. Health Care was probably the hottest political football of CY 09. After the dust settled, the sector fell out of favor in the first half of CY 10. Since the Apr 10 peak in equity however, Health Care has regained favor and appears another defensive play.
8. Utilities almost mirror Health Care for the first half of CY 10. We are, however, seeing what one would expect should the market be turning defensive - namely a sharp rise in the relative strength plot against the S&P 500. This sector, perhaps more than any other, confirms moves into Staples and Health Care, and is decidedly defensive.
9. Financials have been a measuring stick in identifying potential bottoms in equities in recent years, but the aforementioned volatility in these stocks have pushed this theory to the sideline. While the rise in the first half of CY 10 appears impressive, it's nearly as though the sector has become a beta play to the market itself and should be discounted.

What can we glean from these charts, and what should we look for going forward? US domestic equity has been fighting off some serious support levels for the past few weeks. While some have given way, others have just collapsed during volatile trading sessions. Technicians should not turn their backs on the defensive posturing unfolding before our eyes, and are advised to study the market for rises in equity amidst poor market internals. Its summer, so volume is expected to be relatively light, and readings in RSI and others may lend guidance regarding whether or not this is nothing but a rally in a new cyclical bear - or if we can find our footing again and make new highs.

Jeffery E. Lay, CMT
President
Talon Eight, LLC

Disclaimer: This post is intended solely to disseminate information, and is not, and shall not be construed to constitute financial, investment or other similar advice. All posted material should be independently verified for accuracy and current applicability. Readers of this post are referred to the Risk Disclosure for further information.

[Return to Analysis]