Sector Rotation: Short-Term vs. Long-Term

Key Points

• Sector rotation analysis can provide insight into the current state of the stock market that other analysis can’t.
• Relative Rotation analysis shows investors are positioning themselves defensively as the S&P 500 approaches new all-time highs.
• However, deeper analysis shows that this may be a short-term trend.

Sector rotation can tell us a lot about the stock market. It can give investors insights into trend performance and investor sentiment, but it also can tell investors where they should focus, or more importantly, which areas in the market to avoid.

What is Sector Rotation?

First, stocks/companies can be grouped into certain groups called sectors. These companies are usually in the same industry, and they cater to a specific part of the economy. Because they are in the same sector, often times they are direct competitors. 

Sector rotation is the idea that sectors move in and out of favor with investors; i.e., they rotate between under performance and out performance. This occurs because market participants drive stock returns, and when one sector is more in favor, it out performs.

What Can Sector Rotation Tell Us?

Stocks prices are based on the future expectation of performance. When investors believe a stock will be higher than it currently is, they purchase it. If they believe the stock will be lower, they sell it. This is what drives sector rotation.

During certain parts of the economic cycle, different sectors tend to perform better than others. For example, when the economy is growing in the middle of the cycle, investors should expect cyclical sectors like the industrials and materials sectors to outperform. 

The companies in these sectors are driving economic growth by creating and providing the necessary resources to produce the final goods and service for consumers. On the other side, when the economy is weakening, investors should look to the defensive sectors. 

These sectors are defensive because they are companies that provide essential services and products such as toilet paper or health care. Consumers need these products and services regardless of the strength of the economy.

The cyclical sectors, or the sectors that should outperform during economic growth are the industrials, materials, financials, consumer discretionary, energy, and technology. The defensive sectors are the utilities, consumer staples, and health care. 

Sector rotation also tells us about investor sentiment. When we see that defensive sectors are outperforming, it tells us that investors are worried about the future. The defensive sectors tend to be less volatile during times of market volatility. When investors are bullish we see the the more volatile sectors rise faster, and investors position themselves in that way.

In the rest of this blog, we will use sector rotation analysis tools to determine the current state of the stock market, investor positioning, and what it all means.

Relative Rotation

The Relative Rotation Graph uses price action to determine sector performance compared to the S&P 500. This graph literally shows how sectors are rotating in and out of favor. 

Currently materials, industrials and financials are in the lagging quadrant in the bottom left, while technology and energy are moving towards it. Consumer staples is the lone sector in the improving quadrant, while health care, utilities, and consumer discretionary are in the leading quadrant.

The current setup of the Relative Rotation Graph is a little concerning. The three defensive sectors are performing better than five cyclical sectors. Only consumer discretionary stocks are  in the top half of the graph, and even so, it is very close to moving into the weakening quadrant.

Ratio Charts

These charts use a ratio to determine performance. an investor can put any two assets together to determine which is performing better relative to the other. This works by dividing one security by another. When the chart is moving up, it means the top security (as a fraction) is outperforming. 

When the chart is moving down, the bottom security is stronger. In our case, when the chart is moving up, it means the sector is performing better than the S&P 500, and it is a positive for the index. When the chart moves down, the sector is lagging the S&P 500, and it is detracting index performance. 

However, the most important thing about these charts is that we can use traditional technical analysis on them.

Cyclical Sectors

The technology and consumer discretionary sectors are the strongest performers. Technology has been leading the S&P 500 since 2014, and has maintained this trend since. Mean while, the consumer discretionary sector has recently broken out of a sideways channel, which could be a sign of more longer-term out performance.

The energy sector has been under performing since 2014, but it may have broken that trend, We will want to watch this chart to see if the out performance can continue.  

Industrial and materials stocks have been weak this year, as illustrated by their ratio charts. Materials has broken an upwards channel indicating future weaker performance. 

Industrials has remained above a support level, which is a good sign, but the ratio chart has failed to move up since the start of the year. However, since the ratio has remained above the support, we remain bullish on the sector.

Defensive Sectors

All three of the defensive sectors are in under performance down trends. Healthcare is trying to break that trend, so we will need to watch to see if it can find a new uptrend. 

Conclusion

First, we looked at the Relative Rotation Graph. This told us that investors are positioning their portfolios defensively. In the short-term, investors have been buying more of the defensive sectors, which has pushed these stocks higher faster compared to the S&P 500 and the other sectors. Meanwhile, the industrials, materials, and energy have been underperforming, as investors look for opportunities in the defensive sectors.

Second, we looked at the individual ratio charts. These charts show longer-term trends, and they help put the Relative Rotation Chart in perspective. These charts show the relative out performance of the defensive sectors is minor in a longer term perspective. 

While the defensive sector ratios have moved up over the last few weeks, the long-term trends show that technology, consumer discretionary, and the industrials are still in control over the long-term. 

However, it is not all clear skies. The materials sector continues to weaken, and financials are struggling. But these sectors could possibly be explained by the trade disputes in the global economy, and the fact that treasury yields have failed to move meaningfully higher. 

What Does it Mean for the S&P 500?

First, we need to point out that the S&P 500 is approaching all-time highs. Defensive positioning as the market goes higher is a signal of something. Normally, we want to see the cyclical sectors take control at this point, in order to lead the index higher. Since this is not the case, it is probably a sign of future volatility. 

Visit https://www.brtechnicals.com/sector-rotation-short-term-vs-long-term/ to see all of the charts!

Submitted August 13, 2018 at 04:19PM by BR-Technicals https://ift.tt/2nxSMp0