Friday, February 15, 2013

Sector Rotation: Watch for Weakness in Financials and Discretionary

We look for patterns in the nine $SPX sectors every week as a tell for overall market direction. Yes, it's part of the Weekly Market Summary. For example, in autumn 2012, when $SPX fell for two months into November, the fact that financials and consumer discretionary had so strongly led the advance gave confidence that the market would continue higher.  And it has.

The charts below review how sectors performed on a relative basis through the past 10 years, a period that includes at least a cycle and a half. 2013 is off to a good start, but its been a mixed bag, with defensives up with cyclicals. As explained below, watch for weakness in consumer discretionary and financials combined with strength in utilities as a sign of a trend change. Not yet. 

The first chart shows three stages of a cycle. Within each are the sectors that typically lead: financials and consumer discretionary usually lead early in the uptrend, energy late in the uptrend and defensives lead during downtrends. More simply, cyclicals lead on the way up and defensives on the way down. 

In the charts below, defensives are the three to the right before financials. Above the horizontal line means they outperformed $SPX, and vice versa below the line. 

2003 - The start of a new uptrend (stage one). SPX bottomed in March. Cyclicals led, especially technology and consumer discretionary, as you would expect. And defensives all got buried. 

2004 - an irritating pause year where $SPX moved sideways. There is no pattern within the sectors as investors don't know whether to seek risk or safety. Dividend paying utilities were a good place to wait things out. War in the Gulf influenced energy.

2005 - a second pause irritating year.  SPX was flat until November, then took off. Like 2004, dividend paying utilities were popular while beta chasers got nowhere.

2006 - uptrend resumes (stage two). SPX rose 14%. As a group, defensives underperformed and cyclicals outperformed. Note financials and consumer discretionary are cyclical leaders.

2007 - more uptrend, ending with a peak in late October. This is the cycle top. Energy prices spiked higher. Note in particular the underperformance of consumer discretionary and financials. A nice tell, together with defensives, that something was changing. Text book perfect.

2008 - SPX collapsed 40% (stage three).  Defensives massively outperformed. Consumer discretionary is the outlier but recall it peaks first and therefore also bottoms first.

2009 - cycle bottom again (stage one).  SPX rises more than 20%. Cyclicals outperform. Consumer discretionary and technology lead with materials. No one wants defensives.

2010 - another up year. SPX up 13%. Defensives lag. Consumer discretionary leads (stage one) by a lot.

2011 - irritating pause year, like 2004 and 2005. SPX flat. Like those years, defensives outperformed. Financials underperformed a fifth year in a row. But discretionary outperforms a fourth year in a row.

2012 - uptrend resumes, like 2006, with SPX up 12%. Financials were the dark horse and led the market higher as did consumer discretionary for a fifth year. A nice tell that the trend higher is intact.

2013 - strong start. To date, energy is the big leader (stage two), but it's otherwise a mixed bag with defensives up and technology and materials (cyclicals) down (stage three). It's early, and all nine are hitting highs, but the key watch outs are (1) defensives, especially utilities, leading and (2) stage one cyclicals, especially financials and consumer discretionary, lagging.