Sector Relativity

Zacks

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 another stage.

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 recovery peaks.

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 us...

'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 place.

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:

Housing resurgence

Resilient consumer

Record corporate profits, and cash reserves

QE Infinity

Low interest rates and low inflation

Technological innovation

Energy independence

Healthcare boom

China soft landing and new regime leaning toward stimulus

Steady growth that avoids boom-bust extremes (less excess = more shallow contractions)

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 ETFs 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 reasons...

1. Financials had a great 2012 (top-performing sector near +25%) as Federal Reserve QE programs and low interest rates continue to give them support.

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 more years.

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:

3-months: 6.3%

6-months: 18.3%

1-year: 23.7%

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 'fracking').

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. Industry

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 stocks.

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 Zacks.com

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