The Dual-Edged Sword of Investing: Risk vs. Reward
By Chris Puplava, April 10, 2010
Co-Manager of PFS Group's Precious Metals Managed Account, Energy Managed Account, and Aggressive Growth Managed Account
Two common themes I have been writing about over the last six months are sector rotation and contrary investing. I believe we are still within the confines of a secular bear market, and in that context asset allocation (stocks vs. bonds vs. commodities, sector weighting) will likely play a key role in investor returns as it did in the 1970s secular bear market. Current leading economic indicators (LEIs) appear to be topping and such an event should have broad implications for sector leadership going forward. Quite fortuitously, the defensive sectors that outperform when the LEIs are turning down are deeply oversold on a relative basis versus the S&P 500. At the present time, the risk versus reward balancing act appears to favor traditionally defensive sectors.
As stated above the growth rate of the LEIs for the U.S. economy are well within their upper range and are far more likely to roll over than accelerate ever higher. For example, the growth rate in the Economic Cycle Research Institutes (ECRI) Weekly Leading Index (WLI) is at its highest levels in the history of the series and is likely to cool going forward.
When the WLI growth rate slows the non-cyclical sectors of the economy, such as consumer staples, utilities, and health care typically outperform the cyclical areas of the economy, such as consumer discretionary, technology, and financials. This was the case in the bear markets of 2000-2003 and 2007-2009, as well as in 2004 when the WLI slowed down to neutral levels. If the WLI begins to roll over in the near future then investors will likely shift towards the defensive sectors, which so happen to look quite attractive from a contrarian point of view as they have severely lagged the S&P 500 on a twelve month relative basis. Conversely, the cyclical sectors have outperformed the S&P 500 to such an extent they are more likely to underperform going forward.
Leaders - More risk vs. reward at this point
Three market leaders over the last twelve months have been the consumer discretionary, financials, and industrial sectors. These three sectors have outperformed the S&P 500 to such a degree that they are at or above two decade extremes. Roughly 95% of the twelve month relative performance observations for the S&P Financials sector are between -27% and +30%, and as recently as a few days ago the S&P Financial sector outperformed the S&P 500 by more than 80%, clearly putting it at a relative performance extreme. Similarly, the S&P Consumer Discretionary and S&P Industrial sectors have also hit their upper range and may begin to underperform the broad market over the course of the next six to nine months.
Laggards – More reward than risk at this juncture
At the other end of the relative performance extreme are sectors traditionally viewed as defensive or less tied to the general economy than cyclical sectors. What absolutely takes the top spot as top underdog is the S&P Telecommunication sector, which has grossly underperformed the S&P 500 by the widest margin in more than two decades. The sector sports the highest dividend yield (5.81%) of all S&P 500 sectors as well as the third lowest trailing P/E (13.58), making it a bargain among its sector peers.
Two other sectors that are also at relative underperformance extremes are the S&P Utility and S&P Consumer Staples sectors. The S&P Utility sector currently has a yield of 4.28% and moderate trailing P/E ratio of 12.87, certainly lower than the 18.93 P/E ratio for the S&P 500 and the sector’s dividend yield is more than twice the yield on the S&P 500 (1.81%). The S&P Consumer Staples sector has an average P/E of 15.86 and a nice dividend yield of 2.83%.
A third sector that looks cheap relative to the S&P 500 is the S&P Health Care sector. The sector’s relative performance has improved as of late after the passing of Obama’s major health care overhaul as the uncertainty of the legislation likely weighed on the sector. While the twelve month relative performance is not quite as attractive as it was when we entered 2010, it certainly is attractive relative to the market leaders highlighted above.
Energy – The Odd Ball
While the energy sector is not considered a defensive sector it has certainly traded like one. Like the laggards mentioned above the S&P Energy sector’s relative performance is at the third lowest point in nearly two decades despite rising energy prices. For the ardent energy bulls this perhaps represents a tremendous buying opportunity on a relative performance basis. While the sector has underperformed the market for the last year there may be change afoot.
The relative strength of the S&P Energy sector to the S&P 500 shows a strong directional correlation with the Conference Board’s Lagging Economic Index and the Lagging Index put in its first positive uptick in February of this year since its prior peak in January 2009. If the Lagging Economic Index continues to improve going forward that likely spells favorable winds for the S&P Energy sector’s relative performance.
Arguing for a bottom actually being in for the Lagging Economic Index, and thus a bottom for energy’s relative performance, is the Conference Board’s Coincident Economic Index (CEI) that leads the Lagging Economic Index by several months. Historically the CEI leads the relative strength of the S&P Energy sector by six months and so we may see the energy sector become a market leader into the fall of this year.
There are two potential catalysts that may lead the energy sector to begin to outperform the broad market, and one is a potential breakout in the Chinese Shanghai Index as China has turned into the marginal commodity buyer in the last decade. Since peaking in August of last year the Shanghai Index has been in a symmetrical triangle pattern, with the definition of a symmetrical pattern provided below from Investorpedia (emphasis added):
Symmetrical triangles, on the other hand, are thought of as continuation patterns developed in markets that are, for the most part, aimless in direction. The market seems listless in its direction. The supply and demand therefore seem to be one and the same.
During this period of indecision, the highs and the lows seem to come together in the point of the triangle with virtually no significant volume. Investors just don't know what position to take. However, when the investors do figure out which way to take the issue, it heads north or south with big volume in comparison to that of the indecisive days and or weeks leading up to the breakout. Nine times out of ten, the breakout will occur in the direction of the existing trend…
As stated above, there is a 90% probability that a breakout will occur in the direction of the existing trend prior to the symmetrical triangle, and in the case of the Shanghai the prior trend was up. The weekly MACD for the Shanghai Index is on the verge of generating a buy signal and the weekly 14-period RSI remains in bullish territory (north of 50), all suggesting the trend in the Shanghai is healthy and a bullish breakout appears eminent.
Perhaps lending further support towards a Shanghai breakout is that the commodity complex is already breaking out in general (minus the agriculture sector), perhaps discounting an eventual Shanghai breakout. My Commodity Currency Pair Carry Index recently broke out to new a high which has bullish implications for the Shanghai which peaked coincidently with the currency index in 2007, bottomed coincidently with the currency index in 2008-2009, and peaked coincidently with the currency index in August of last year.
Base metals are also breaking out with copper, nickel, and tin reaching new rally highs and aluminum testing its January highs. While lead a and zinc are still off their January highs they have been rallying strongly lately and a retest of their January highs may be in the offing given the action in the other base metals.
If the energy sector can rally further a major breakout may be in the cards that could support a turnaround in relative performance versus the S&P 500. The $60 to $62 range has been a key level for the Energy Select Sector SPDR ETF (XLE) and a breakout would likely lead to a quick pop into the upper $60s to mid $70s before resistance is seen. Such a move would likely lead to a breakout in the relative strength of the XLE versus the S&P 500 (lower panel below), which would argue for sector rotation into the energy sector.
A breakout in the energy sector and the Shanghai Index may be signaling a resumption of the commodity secular bull market and commodities versus paper assets in general. The weighting of the energy and basic materials sectors (commodities) in the S&P 500 more than doubled from the start of the last decade to the 2008 top while the consumer-focused sectors in the S&P 500 (Financials, Consumer Discretionary) saw their weighting cut in half over the same period. We appear to be at a crossroads as the weighting of the consumer-focused sectors are challenging a declining trend line that has been in place since the 2005 market top (coincident with the top in housing), while the commodity-focused sectors are approaching a rising trend line.
Given the relative performance extremes highlighted in the first section above, the probabilities favor a bullish turnaround in the commodity-focused sector weightings of the S&P 500 and a resumption of the bearish trend in the consumer-focused sectors weight in the S&P 500. How these trends play out will play a key role in investor performances going forward, and only highlights the importance of asset allocation ahead. Currently the risk versus reward pendulum of relative performance favors the laggards which are the defensive sectors, and the odd ball energy sector which may play catch up with the broad market.
© 2010 Chris Puplava