August 17, 2009

Sector Rotation Model

In his book, Technical Analysis of the Financial Markets, John J. Murphy detailed a sector rotation model regarding the flow of assets and investments in the S&P 500.  The chart above incorporates Mr. Murphy’s acumen, with a Wall Street twist.

The typical long only equity manager takes three months (approximately 60 trading days) to fully acquire an investment position in a security.  Managers do not want to tip their hands.  Were they to take a large position right out of the gate, they would likely move the market too fast, thereby negating a portion of their gains.

Plotted in nine boxes are the nine sectors of the S&P 500 represented by the nine ETF’s of the Select Sector SPDRs.  These boxes each plot a sector specific, colored line chart along with a black bar chart of the S&P 500.   The percentage change is measured over 60 trading days that approximates three calendar months.  A 60 minute period is chosen for the interval.

They are, from left to right, top to bottom:

Left Column, Top to Bottom:

Discretionary (navy)
Technology (blue)
Industrials (silver)

Center Column, Top to Bottom:

Materials (brown)
Energy (red)
Staples (purple)

Right Column, Top to Bottom:

Health Care (violet)
Utilities (turquoise)
Financials (green)

What is clear from the chart is that Financials (right column, bottom box) broke strongly ahead of the S&P500 in late July / early August.  What is not clear, however, is what role the Discretionary sector (left column, center box) has played in the advance.  Typically, in a bull market advance, the Discretionary sector will “pick up” the advancing signal of its leading Financial ETF, and (perhaps in unison, or thereafter) be followed by a pick up in Technology.

To wit, over the past 60 trading days, the Financial ETF is “up” 20.25% to the S&P500’s advance of 11.36%.  Though the Technology sector has advanced 14.23% to the S&P500’s advance of 11.36%, the Discretionary ETF has lagged behind – essentially flat, moving upward only 1.05%.  Further studying the chart, we see the Industrial sector is not advancing either (at least not yet) with an effectively flat 1.52% gain.

What we do see, however, is that the Energy sector (center column, center box) is not leading anything.  While advancing 4.30% in the last 60 trading days, we do not see Energy leading this market – which is a good sign for the moment.  Energy is said to lead at market tops, so this “lag” is welcome news for cyclical bulls.  Indeed, there is no move (despite a brief flash in July to Health Care) of money flowing into defensive sectors including Staples and Utilities.

Technicians should be on the lookout for an advance in Industrials.  The Discretionary sector may pick up, but the next advance should be found herein, an the Materials sector (center column, top box) should move onward as well.  There are some signs of this at the moment, so any move into Energy would signal a possible exhaustion of the current bull move.

When that happens – and it will, pay close attention to the defensive sectors (Staples, Health Care, and Utilities).  All were clearing in control of the market during its decline of late 2008, and money will flow there again eventually.

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.

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