As the economy rolls through its much-anticipated waves of
expansion and contraction, portfolio managers tend to rotate money
from some sectors to others depending upon what stage we are at in
the cycle. The trick, obviously, is knowing where you are at in the
cycle and how long that dynamic will continue before evolving into
In an article this morning, The Economist magazine addressed the
length of the current recovery since the June 2009 recession trough
at 42 months and whether or not job growth would have a chance to
really get rolling before the expansion ended. They noted that
since the end of World War II, the average expansion has lasted 58
months, with the longest being the decade from 1991 to 2001.
Since the 2001 to 2007 expansion is the fourth longest at 73
months, it seems the odds are slightly in our favor for this one to
run a bit longer than 42 months. You would not think so if you
simply listened to the Economic Cycle Research Institute whose
analysis concludes that our economy has been in recession for over
six months already.
But what if the behavior of institutional investors could predict
the next recession better? We all know the cliche here that the
market has successfully predicted 9 of the last 5 recessions. And
the past 3 years of market corrections are proof of that.
Still, even if money rotating between sectors en masse isn't a good
predictor of recession, it may still provide good swing trading
opportunities. Below is the classic diagram of sector rotation
within the economic cycle, as often touted by Sam Stovall of
Standard & Poors.
One important theme that this analysis offers us is that while any
given bull market and its associated economic expansion are
definitely connected and feed off of each other, they are not
necessarily tied at the hip.
In other words, we know that the bear market often bottoms before
the recession does and the bull market can put in a top before the
Another thing to keep in mind is that the cycle and sector rotation
model is just that a rough guide to how the cycles tend to work,
not a mechanical blueprint. As my colleague Kevin Matras reminds
"Each recession and recovery can look a bit different however with
its own unique set of characteristics.
The most distinguishing thing from this bull market recovery and
previous ones was the absenteeism of the housing market. That seems
fitting given it was the imploding housing market that essentially
caused the financial crisis and ensuing recession in the first
Unlike previous recoveries, the housing market was slow to respond
this time around. And that, in turn, helped keep the economy
growing at only 2-2.5% on average, rather than the more typical
4-5% as in recoveries past."
What else makes this recovery and bull market completely unique?
Unprecedented monetary stimulus and record low interest rates for
as far as the eye can see.
The arguments in favor of this bull cycle continuing and avoiding
recession are numerous:
Record corporate profits, and cash reserves
Low interest rates and low inflation
China soft landing and new regime leaning toward stimulus
Steady growth that avoids boom-bust extremes (less excess = more
The last idea is another conclusion from Kevin Matras.
Given this backdrop, I want to look at specific sector and index
relationships to see if we can get some clues about the market's
next moves. My assumption is that while it may be too difficult to
figure out if the economy is poised to give corporate earnings a
boost or a hiccup, we can at least follow trends in sector money
flow to time our trades for the next quarter.
Relationship #1: Staples vs. Discretionary
Below is a 3-year weekly chart which plots a ratio of two sector
against the S&P 500. The black and red line is the ratio of the
SPDR Consumer Staples ETF (XLP) over the SPDR Consumer
Discretionary ETF (XLY).
The ratio line is black when Staples are rising relative to
Discretionary, and it is red when the ratio is falling. Plotted
behind is the corresponding movement of the broad index.
One thing that jumps out immediately is that when the broad market
is headed into a correction, money pours into Staples at the
expense of Discretionary. And when the market bottoms and turns
upward, money flows the other way out of safety and into
economically sensitive consumer areas.
As 2013 gets rolling, the ratio is below both troughs of 2012 and
is flirting with levels not seen since the bull run tops of 2011.
Note that all 3 of those prior lows were fairly solid indicators
for a market turn lower. Now this may be merely a coincident
indicator and not necessarily predictive.
But even for short-term swings in economic sentiment, it seems to
make sense that money could move this quickly from safety to risk,
and back, if there are genuine market concerns about a contraction.
Relationship #2: Utilities vs. Financials
Here we have a ratio SPDR XLU over XLF -- which should show signs
of topping if the cycle were near the later stages of a bull market
and economic expansion.
Why? Because safe Utilities would have been in demand and risky
Financials shunned as the recovery peaks, interest rates rise, and
mirages of recession are seen on the horizon.
Instead, we know the landscape is considerably different for a few
1. Financials had a great 2012 (top-performing sector near +25%) as
Federal Reserve QE programs and low interest rates continue to give
2. But the XLF is still down nearly 45% over 5 years while the
S&P is inching out new 5-year highs.
3. Utilities had a fire sale relative to the market last year
because of looming dividend tax increases.
Despite these exceptions, this is still a relationship to watch. If
the ratio starts moving back toward 2.5, I would expect the market
to be going the opposite direction. And a move back into utility
stocks in Q1 and Q2 of 2013 would not surprise me at all.
The other big lesson here is that a brutally crushed sector
eventually fights its way back in a bull market. Those investors
waiting for their bank stocks like Citigroup, Bank of America, and
Goldman Sachs to regain their former glory could be waiting a few
But playing the sector as a whole finally turned out to be a great
idea as the XLF owned the top spot among sectors for 3, 6, and 12
months with these returns as of January 4:
Relationship #3: Industrials vs. Technology
This relationship is the least conclusive or foretelling, but it
does offer a unique window on equity sectors that we may want to
reference in the future.
Since Industrials and Technology can be subject to effects found on
the early-stage end of market-economic cycles, we should not be
surprised to see Industrials lead both advances and declines in
this steady-as-she-goes bull market, full of fits and starts but
generally trending higher.
The disconnect that stands out is the second half of this year when
Industrials continued to lose ground against Tech after the spring
swoon. Then they snapped back hard. A lot of this was due to
Apple's parabolic rise from May to September and then its reversal
as Tech in general saw a lowering of expectations.
The next turn lower in this ratio (money rotating away from
Industrials and into Tech) could signal further weakness to come in
the broad market as optimism about US manufacturing and the rebound
in emerging markets wanes and Tech picks up an oversold, value bid.
But this is also one of those ratios that can go sideways as the
S&P rallies, as the rising tide lifts all boats. Late 2010 and
2011 are proof of that tendency.
Relationship #4: Healthcare vs. Energy
Here's another one where you would expect a solid correlation like
that of Staples vs. Discretionary, as one side speaks of safety and
the other of growth.
The sector swings in 2010 and 2011 certainly bore this out. But
2012 was a much different tale for two reasons that flipped the
conventional wisdom on its head.
First, the Energy sector is going through an amazing phase of
technological efficiency colliding with vast new domestic supply.
While crude oil spends most of the year under $100 per barrel, US
exploration and production companies continue to exploit new
sources of oil and gas with advanced drilling and recovery
techniques like horizontal drilling and hydraulic fracturing (aka
This perfect storm of geology and technology has seen North Dakota
surpass the smallest OPEC member, Ecuador, in daily production,
keeping a lid on oil prices and integrated margins.
Second, Healthcare in general has benefited from the Patient
Protection and Affordable Care Act, even while specific industries
like health insurance stumble. Coverage for more Americans means
higher revenues for hospitals and drug companies, especially with
an aging boomer population in need of more care.
The reason we want to keep an eye on these two sectors is for a
possible reversion to the mean. As I write today, oil prices are
holding their own over $90 per barrel for the first time in many
weeks. If there is one sector that could play some catch-up next
year, it could be Energy.
Sector vs. Sector is Built on Industry vs.
In any of these relationships, which sectors the money comes from
and flows to is not always easy to figure out at first. But with
investors spending most of the fourth quarter of 2012 trying to
anticipate the tax and spending policies which would impact their
favorite sectors the most, the first quarter of 2013 could be where
big direction changes happen and new relationships are in focus.
Another window to get an early gauge on sector movement is the
Zacks Industry Rank, which classifies over 250 industries and ranks
them according to the earnings momentum of their constituent
If you look at the top 50 to 75 industries in the Zacks Industry
Rank, you can get a good idea of where the earnings momentum
strength is. Right now, you should not be surprised to see strength
represented here by consumer companies (both staples and
discretionary), construction industries, medical/healthcare
industries, and financial companies.
When we see leadership change hands here, it's a good sign that a
shift is taking place in broader sectors too.
Bottom line: No matter which way the indexes go, there will be
solid relative value plays between the sectors to take advantage of
once the trends are identified or turning.
Kevin Cook is a Senior Stock Strategist with
SPDR-SP 500 TR (SPY): ETF Research Reports
SPDR-EGY SELS (XLE): ETF Research Reports
SPDR-FINL SELS (XLF): ETF Research Reports
SPDR-TECH SELS (XLK): ETF Research Reports
SPDR-CONS DISCR (XLY): ETF Research Reports
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