Everybody knows that in order to have a smooth ride on the road you need to have your car wheels checked often.
This approach is not far from what you need to do with your equity portfolio in order to increase your chances of having a smooth and profitable portfolio. Sector rotation refers to shifting your money from one sector to another in order to beat the broad market. The philosophy of sector rotation comes from the fact that certain sectors perform better or worse in different phases of an economic cycle. Factors that can affect a sector’s leadership can be based on both macro developments – such as interest rates expectations, trends in the currency markets, inflation expectations – and psychological factors such as greed and fear.
2014 was a profitable year for all sectors in absolute terms, except from energy stocks. But which sectors managed to do better than the broader market? The table below shows that Health Care and Utilities were the top performers so far this year followed by Technology, Staples and Financials. Note that the numbers below are relative to the broader US Equity Market.
Spotting the turns in the different sectors is not an easy task and while there are a few ways of identifying these, we often prefer to use the Relative Strength (RS) analysis. This is a technical concept that takes the ratio of one sector over the broader market in order to create the Relative Strength chart or RS Line. For illustration purposes we will use a daily 1-year relative strength chart although a weekly chart is recommended in order to smooth volatility and avoid false signals. So let’s take a look at how the different sectors performed relative to the S&P 500 over the year.
Health Care: The Health Care sector was one of the big winners in 2014. The Biotechnology industry boosted the sector further making it the top performing sector. The RS Line below shows a consistent rising trend, with the 50-day moving average staying at all times above the 200-day moving average, thus supporting the uptrend.
Read our technical article on the sector back in September:
Utilities: Second from top comes the Utilities sector. Despite its roller-coaster ride as seen from the RS line below it managed to outperform the broader US market by 16%. We believe that the search for yield was the main driving force behind this outperformance but caution is recommended ahead. When interest rates start rising, they can erode some of the advantages that utility stocks have enjoyed so far this year.
Technology: It was no surprise that the technology sector was among the winners this year. Many contrarians could have bet the opposite as it was too much of a consensus call at the beginning of the year, but being contrarian for the sake of being contrarian can often be very dangerous. In fact the majority can often be correct; it is on the turning points that problems arise. So unless we see over-extended valuations and sentiment indicators reaching extreme levels, then the crowd could be right. Our RS line below shows a healthy rising trend with the 50-day moving average solidly above above the 200-day one, confirming this uptrend.
Financials: Although Financials had a difficult ride for the most part of 2014 we believe that this is about to change. Financial got a shot in the arm in the beginning of December as the Labour Department reported that the U.S. added 321,000 new jobs in November, far exceeding consensus forecasts. This can lead to rising loan activity. Looking at our relative chart below we can see a “golden cross” developing where the 50-day moving average crossed above the 200-day moving average. After a long underperformance it may be the turn of financials to lead the way.
Consumer Staples: Known for their defensive nature, Consumer Staples often do better than the broader market during choppy or adverse market conditions. This is evidenced in our relative chart below when the S&P 500 dropped by about 10% during October. As a reminder, a rising ratio indicates that the numerator is outperforming the denominator. As long as our view on equities remains positive, Staples should continue to underperform the broader market. However, if our RS line below continues to rise, this might indicate that the market anticipates another correction ahead.
Energy: Energy was the sector with the most publicity in 2014. It was the sector in which one could have made a considerable amount of profit or a huge loss. We identified the opportunity to make money in the sector in early April when oil prices crossed above $100 and when we noticed the relative charts of several oil-related industries crossing above major downtrends.
The opportunity however was short lived, as it lasted for only three months. As oil prices turned south so did oil-related stocks, which once again reminded us how intermarket relationships can affect sector rotation. Looking at the rear view mirror there were many clues investors could have used in order to exit the sector in a timely manner. First was the deterioration of the RS line once it crossed below the 50 and 200-day moving averages. Second, the “death cross” below gave the final verdict confirming that energy stocks were in underperformance mode. Although many believe that energy stocks are now a “buy” we believe that more technical evidence is needed.
Consumer Discretionary: Despite their cyclical nature the Consumer Discretionary sector was down versus the broader market for the year. We believe that this is correlated to the price of oil. During the first half of the year oil was trading close to $100, eroding consumers’ disposable incomes. As shown by the RS line below it was not until early November that the sector started to outperform the market. At that time oil was in a clear downward trend. For this sector to do better than the broader market we need to see consumer confidence rising and oil prices remaining depressed. Although the November – December outperformance is meaningful, it is not enough to provide a buy signal for the sector.
Materials: Materials have also had a weak year-end, underperforming the broader market by about 4%. The sector started to underperform in October as seen in the RS line below. There are four major industries in this sector: metals and mining, agriculture fertilizers, paper and forestry products and chemicals, and they don’t move in lockstep with one another. However, almost every part of the materials market is cyclical and investors have to be prepared for significant ups and downs. Everything from bad weather, falling commodity prices, a slowdown in economic growth, a rising dollar and more can affect material stocks.
Industrials: Industrials have had a rough year as well, despite the robust performance of the transportation industry. The chart below shows that the underperformance which started in June lasted until early October. Since then we have seen the sector reviving but not so much in order to confirm a change in leadership.
As we mentioned in the first paragraph, psychological factors also affect a sector’s performance. Sentiment is certainly one of them. As is often the case, this was manifested in the predictions going into 2014. So it is worth asking what those predictions were for the two top sectors – Utilities and Healthcare. In a Barron’s December 2013 poll, 8 out of 10 of Wall Street’s top strategists had advised “avoiding” the utility sector. This was by far the most “hated” sector for 2014. Similarly, only 1 in 10 had favoured Healthcare. You can be sure that these strategists were, in turn, advised by an army of both fundamental and technical analysts. How did they get it so wrong? That’s the beauty of the markets – they humble most participants.
Costas Pierides CFTe, MSTA
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