Sector Rotation

Mid & late-stage cyclicals positioned for the next phase of this cyclical bull market

By Chris Puplava, December 23, 2009

A key tenant to profitable investing is being in the right areas at the right time. For example, during the highly inflationary 1970s the best performing sectors were basic materials and energy (commodities) while inflation-sensitive sectors such as financials and consumer discretionary performed poorly. In the 1990s there was the advent of the Internet and a technological revolution and the returns from the technology sector were far above the other S&P 500 sectors. However, investing in technology this decade has led to disappointment as the sector was working off rich valuations that built up during the prior decade as the technology bubble burst.

The above examples illustrate how long term macro fundamentals shape various sectors performance relative to other sectors and the broad market. In addition to broad fundamental factors there is a typical pattern seen in how various sectors perform throughout the different periods of the business cycle, and rotating one’s investment capital to the sectors that are poised to perform the strongest during each phase of the business cycle has shown to lead to superior returns and led to the advent of sector rotation investing.

Sector rotational investing was mainly conducted by investment professionals but is now practiced by a wider audience, thanks to investment books on the topic and the advent of exchange traded funds (ETFs) that mimic the performance of the ten S&P 500 sectors. The Bible for sector investing was written by Standard & Poor’s Sam Stoval who wrote Sector Investing in 1996. Based on Sam Stoval’s observations of the ten different S&P sectors response to the business cycle, John Murphy from StockCharts.com created a sector rotational model that highlights which sectors perform best during the stock market and business cycle. As stocks discount economic news in advance the stock market cycle (red area) leads the economic cycle (green area) by an average of six months as seen below.

Source: StockCharts.com

As seen in the sector rotational model above, the consumer cyclical (consumer discretion) and technology sectors typically perform the best after the conclusion to a bear market and are later followed my mid-cycle (industrials) and late-cycle (basic materials and energy) sectors. The defensive consumer staples and health care sectors often perform best just as the economy is peaking. This stylized cycle this year has played out exactly as the model suggests and is a near perfect replay of the 2003 stock market bottom in which the early cyclicals like technology and consumer discretionary outperformed the mid and late stage cyclicals such as energy and industrials.

However, as the last bull market matured mid and late stage cyclicals like industrials and energy significantly outperformed the broad market (S&P 500) and the other S&P sectors. As seen in the figure below the energy sector significantly dominated all other sectors by a sizable margin in 2004.

As 2009 was a replay of 2003, I believe that 2010 will be a replay of 2004 and that the mid and late stage cyclicals will significantly outperform the broad market. Industrials, basic materials, and energy are the next three sectors in line to be the top performers in the sector rotational model and may be worthy of investment research heading into 2010.

Source: StockCharts.com, PFS Group

I believe that the economy will continue to improve in 2010, though the major headwinds of high unemployment and runaway deficits that will prove more and more difficult to fund will likely cause the economy to sputter in the later portion of 2010 and heading into 2011. If this scenario plays out then defensive sectors should begin to outperform the broad market and other sectors in the later portion of 2010, which is not that far off as this cyclical bull market is unlikely to last as long as the 2003-2007 cyclical bull market. Closer look at the industrials, basic materials, and energy sector are provided below.

Source: StockCharts.com, PFS Group

Industrials

The S&P 500 Industrial Index has lagged the broad market (S&P 500) since the middle of 2008 and has now reached an oversold level that has often marked periods where the sector begins to outperform the S&P 500. A few months ago a buy signal was given and that fact that it occurred in oversold territory gives it more credence than if it occurred in neutral to overbought territory indicating the sector may be a top performer in 2010.

In addition to the attractive relative performance profile for the sector its valuation composite is still cheap as its valuations are below those seen at the 2002-2003 market lows after being severely oversold earlier this year.

Within the sector the most attractive industry is Capital Goods, which is as oversold as it was at the major low seen in 2000 when the industry began to significantly outperform the market. The industry is currently on a buy signal given in September of this year. The industry was highlighted back in the middle of August (The Most Attractive Sector in the S&P 500?) as worthy of attention. Since then a buy signal was given and the industry has outperformed the S&P 500 by 4.3% (14.1% vs 9.8%) and has considerable room to run before it reaches relative performance overbought territory. Although not updated in this article, a fundamental table was given in the August article (click link above) of the members from the S&P 500 Capital Goods Index which readers may be interested in viewing as a starting from which to do further research.

Basic Materials

One of the hallmarks for sectors that are in their own personal secular bull or bear markets is that they will spend most of their time outperforming the market in secular bull markets and underperform in secular bear markets. In the 1990s the commodity sectors such as basic materials and energy spent most of the time underperforming the S&P 500. However, things changed this decade as the materials sector has spent the bulk of its time outperforming the S&P 500. This pattern can be seen below with the S&P Materials sector currently on a buy signal and its outperformance trend remains in tact.

While the materials sector is currently on a buy signal its valuation composite shows that its valuations are a bit frothy and so investment at these levels carries a certain degree of risk. Valuations can improve by the sector undergoing a correction or fundamentals may improve in which sales and earnings accelerate to bring price multiples back down. Given the strong technical performance of the sector it appears the market is discounting that fundamentals are set to improve rather than a dramatic price decline to bring in valuations.

Energy

Like the basic materials sector, the energy sector has spent the bulk of this decade outperforming the S&P 500 as commodities remain in a secular bull market. Currently the sector’s relative performance is at a point that marked the low for the sector seen in 2003 before it had a monster year in 2004 (see third chart from the top above) and is quite attractive after working off the heavily overbought condition seen in 2008 when a timely sell signal was given.

Like the industrial sector the valuations for the energy sector remain neutral and do not show the froth that other sectors do as valuations are not a concern at this point.

As energy is a mid to late-stage cyclical, an improving economy should lead to the sector’s outperformance of the broad market, which should take place next year according to the ISM’s Manufacturing New Orders Index. The New Orders Index typically leads the relative performance of the energy sector by about ten months and the New Orders Index underwent a “V”-spike recovery this year which means that we could see a sharp (“V”-spike) recovery in the energy sector’s relative performance profile in 2010.

The average sector correlation to the S&P 500 has been steadily falling (inverted below) indicating that sector and stock selection will likely play a larger role in 2010 than in 2009 in which a rising tide lifted all boats. A falling correlation indicates that individual sectors are beginning to dance to their own tune as their underlining fundamentals play a greater role in their returns than the overall market. This occurred in the early 1990s when health care outperformed the S&P 500 and the average correlation fell from 0.90 to roughly 0.65. During the later part of the 1990s most sectors were peaking and yet the technology sector continued higher as the average sector correlation fell to a low of 0.45. After last year's brutal bear market the average correlation was driven nearly to a perfect correlation of 1.0. However, since November the correlation has been falling which indicates that sector selection is becoming more important.

If sector and stock selection are to play a bigger role in 2010, then (as highlighted above) the mid and late-stage cyclicals should perform well and would be next in line in terms of the sector rotational model.

Chris Puplava

© 2009 Chris Puplava

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Christopher M. Puplava
PFS Group
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