The Business Cycle and Sector Rotation, Part 2

November 25, 2008


In Part 1 of this study, I laid out some basic principles of Inter-market dependencies and sector rotation.  Today, I’ll apply what we discussed to our current market.


The Benchmark Business Cycle

As you may recall from yesterday’s post, we talked about the six general stages of the economic cycle.  Below is the same diagram for reference.

Figure 1
Benchmark Business Cycle


To see where we might be, I’ve attached two charts below.  The first is the S&P 500 and bond prices (inverse of the 10 year yield).  The bottom chart shows commodities and the dollar.  In normal times, the dollar moves inversely to commodities, so I showed it just for information.  It won’t be part of our discussion.



Figure 2
Stocks and Bonds, Long Term


Figure 3
Commodities and Dollar, Long Term

On the first chart, you can see that the last bear market ended near the end of 2002.  Bonds had just turned up, and as stocks bottomed, bonds continued to rise for about 6 more months.  All three markets were briefly rising at the same time, which puts us in Stage 3 during the first half of 2003. 


Note that normally, stocks would turn up before commodities (Stage 2 then Stage 3), but most commodities turned prior to the market bottom this time.  The exception here was copper, which followed the normal pattern of turning after stocks.


In mid-2003, bonds turned down, while stocks and commodities continued to rise.  This is Stage 4, which is the early recovery stage.  As the recovery progressed, over the next 4 years, bonds continued to trend downward (rising interest rates), while the S&P 500 nearly doubled, from 800 in 2003 to over 1550 in mid-2007.


In October, 2007, stocks turned down for what would become the start of the current bear market.  This would lead us to believe that we had entered Stage 5, the top of the recovery.  Further evidence came when commodities turned down nine months later.  That final commodities top signified a Stage 6 situation, in which economic contraction begins to gain momentum.

The Bond Anamoly

But wait, what about bonds?  They turned up much earlier than the model says they should (in Stage 1).  In fact, they broke their upper trend line just as stocks were topping out in October, 2007.  How do we explain that? 


This is where the model appears to be a bit dated.  Up until the late 1990’s, when the Asian currency crisis hit, stocks and bonds generally moved together.  They were considered complimentary asset classes.  That simply means that when you invested, you invested in stocks and bonds.  The chart below clearly shows the correlation up through the late 1990’s.



Figure 4
Bonds Turn Before Stocks


But look what happens after 1998:



Figure 5
Bonds Trade Counter To Stocks


The best way I know how to explain this is that stocks and bonds changed from being complimentary investments to competing investments.  This is the so-called “flight to safety” trade.  As bonds are bought, money comes out of stocks, and vice versa.  Whatever the reason, it is there, and has been for 10 years.

Knowing Our Place

Getting back to our Six-phase model, we last mentioned that commodities turned down in July, 2008, nine months after stocks peaked.  This would put us into Stage 6.  However, as we just saw, bonds have already turned up, so does this put us into the next phase of the model?  Yes, I think we are in Stage 1, which is Early Contraction. 


I believe the evidence is clear that we have entered into a recession:  unemployment is 6.5%, GDP just turned negative (on initial revisions only).  Inflation is not even a remote fear right now, even as the Fed prints money.  Deflation, ala Japan in 1990, is the greater fear in the markets right now.  The rapid and violent drop in commodities, from July through today, is another piece of the deflation-fear puzzle.

Looking Ahead

So then, If we have truly entered the initial stage of recession (Stage 1), we should be getting close to the bottom, or worst part of the recession soon.  That will be marked by Stage 2, when stocks turn up.  Of course, that will also mark the beginning of a new bull market, despite being at the trough of the recession.


Things to look for to see if we have, or will soon enter Stage 2:  unemployment leveling off, housing stabilizing or actually improving, consumer sentiment improving, etc.  Many economic indicators are currently at multi-year extremes.  Those that aren’t yet are expected to be in the next few months.

Sector Rotation - Where to Invest?

Now that we’ve looked at the macro view, and decided that we believe we are in the early to mid phase of the contraction, let’s see what the sectors are telling us.


I’ve shown the same graphic as yesterday for reference:



Figure 6
The Sector Rotation Cycle


To represent the various sectors, I like to look at the following ETFs.  The colors correspond to the same colors in the chart discussed below:


Figure 7
Sector ETFs
Some Required Math (my apologies)
In order to compare the relative strength of each sector, the following charts need a bit of explanation.  I measure sector strength by how the group compares to the S&P500.  This is called “flattening” the index, because all movements are divided by, or normalized to, the index.  For example, consider the following series of values:

















Both sets of values are increasing from left to right, but we learn more about the strength of one versus the other by dividing the Sector / Index:


Sector/Index = 1.0, 1.04, 1.02, 0.98, 0.96, and 0.93


From the first value to the second, 1.0 to 1.04, the sector is outperforming the index.  It’s ratio is increasing.  From the second value through the end, the sector is underperforming the Index, since the ratio is decreasing. 


By taking the ratios of all sectors against the index, we have a good basis for comparison.  We have effectively taken out the effect of the general market, and have isolated the part of each sector’s move unrelated to the market, which is what we want to study.


In this example, although the Sector is still increasing in value, it is becoming out of favor because it is losing relative strength against the market.  When this happens, there is always another group that is gaining strength against the market.  This is the core of sector rotation, as we shall soon see.

Almost Done...
Lastly, there is one more “normalization” I did to make the data easier to view on charts.  After dividing each sector by the index and charting their values, I noticed that the lines were very spread out based on the actual magnitude of each index (1000/index was way above 50/index).  This flattened out the lines, and made it impossible to interpret. 
The way to fix this was to normalize each sector to itself.  This is done by dividing all the data by the first value in the chart.  Each successive data point is shown as a change from that point, which is always 1.00.  You’ll see what I’m rambling about in the charts below.


Finally, The Good Stuff:  Sector Rotation

Looking back over six months, we see the rotation out of Basic Materials (represented by Metals & Mining and Materials) and Energy, then into Consumer Staples and Utilities. 


Figure 8
Recent Sector Rotation

As you can see from the chart, first two groups peaked in July.  By October, the second two groups began to outperform them.  Referring to Figure 6, Basic Materials and Energy carry us through the Late Expansion phase of our economy, while Consumer Staples and Utilities usher us into Early Contraction.


Figure 9
Our Current Place in Sector Rotation


To help get our bearings and gain some perspective, let’s work backward two years, and see how the situation has changed.  Taking a look at the chart below, we can see that Consumer Discretionary (Cyclicals) and Technology were the leading groups.  Even financials were above the mid-line.  Energy, Metals, and Materials were some of the most out of favor groups.


Figure 10
Sector Strength 2006 and 2007


Also notice that the “defensive” groups, Staples and Health Care, are also conspicuously out of favor.  Using the same logic as above, we appeared to be entering the early expansion during late 2006/early 2007:
Figure 11
The Way We Were
Keep an Eye Out for Rotation

Finally, we’ve had an interesting counter-trend move over the past 3 days.  Take a look at the chart below, which is a 30-minute chart in the month of November.  We can see more intra-day detail here. 



Figure 12
Short Term Sector Strength


Coming out of a horrible October, in which everything sold off, we see that the typical defensive groups led the strength:  Staples, Utilities, and Health Care.  Financials and Metals were the weakest groups at the start of November. 


Now notice what has happened in the past 3 days:  The weakest groups have turned sharply higher, while the defensive names have dropped significantly.  Based on our discussion above, we know that Staples and Utilities are the current strong, or in favor, groups.  But are they rotating out already?


Looking at the Sector Circle diagram, Figure 6, we would expect Financials to be the next group to excel.  Clearly they have been out of favor for over a year, but they will eventually lead us out of the contraction phase.  The action over the past three days can only be one of two possibilities:


  • A simple oversold rally, temporarily counter to the prevailing trend:  defensive stocks strong, or
  • The bottom is being put in for the financials, and rotation will move forward to the next step in the circle.
I think the first option is most likely, since it is only a 3-day trend, after all.  However, we now have a focal point for looking for leadership change.  If financials reverse and go back down from here, we can expect Utilities and Staples to continue to outperform.  On the other hand, there will be a time when financials will outperform the defensive groups.  This may be starting to happen now, or it may not happen for months. 
The way I watch for these shifts is with ratio charts.  Simply make a chart of financials divided by staples, for instance.  Watch for trend changes.  Here is the XLF/XLP:
Figure 13
Financials vs. Consumer Staples
The top is just chart of XLF and XLP individually.  The bottom shows the ratio XLF/XLP.  When the ratio is going down, that means that XLP is outperforming XLF.  When the line trends up (which is hasn't for the duration of the chart), then we'll know XLF is outperforming XLP.
Let's compare financials to utilities (XLU):
Figure 14
Financials vs. Utilities
Finally, Health Care (XLV):
Figure 15
Financials vs. Health Care
Let's look at the same relationships against Technology (XLK):
Figure 16
Technology vs. Consumer Staples
Figure 17
Technology vs. Utilities
Figure 18
Technology vs. Health Care
Bottom Line
Keep an eye on the relationship of financials and tech to defensive groups.  When the banks/tech show consistent strength against the staples, utilities and health care, you will know we have moved on to the next phases of the cycle.  When that happens, we will know that Financials, Cyclicals, and Technology should lead the way higher.  Of course, finding the right industries and stocks within those sectors will be the next challenge, but we can tackle that another day.  Nobody said this would be easy.
We've discovered that the business cycle is in the early to mid-contraction phase.  The stock market, on the other hand, is in the depths of a pretty strong bear market.  Given all this, we discovered that the traditional sector rotation groups are performing as expected:  defensive names are strong, commodities weak, financials bottoming.
The important things to note are:
  • Always consider where you think we are in the economy and in the sector rotation chart before investing
  • Why invest in groups that just went out of favor?  Look ahead to which groups are coming up.  These are likely to be groups very much out of favor for quite some time, and it may be painful to buy the out of favors.
  • Watch financials and technology vs. staples, utilities and health care right now.  This relationship will change in favor of financials and tech eventually, and you will want to look ahead to the next groups for investment winners.
  • Be flexible and objective.  The models presented here are just that, models.  Things don't always go as we think they should, but these are excellent guidelines to keep in mind as you invest.
  • The leaders of the last bull market are not the same ones who will lead the next bull market
  • Don't trade the market you wish was there.  Trade the market that exists.
If you made it this far, congratulations.  You've spent the time to arm yourself with important sector rotation knowledge that will pay you dividends in your investing career.
Have a Safe and Happy Thanksgiving.
Dan Grill