Sector Rotation – Adaptiv

Want to Make Great Investment Decisions? Just Look Left.…

December 2, 2014April 13, 2022

Using a weight-of-evidence approach is valuable for making quality decisions on desired or current investment positions. As technicians, we have a wide variety of tools at our disposal to anticipate potential rough spots, corrections, or buying opportunities. But that is all they are – tools of warning or anticipation. They give us an edge in identifying when and where to take on risk with limited downside. Finding asymmetric risk/reward opportunities is the epitome of what we do at 360 Investment Research. We don’t care about being right. We only care about being on the right side of the trade.

Over the past 5 posts, we’ve identified some warning signs for the overall U.S. equity markets. All of the posts carry weight as we analyze our long exposure to U.S. stocks. But none is more important than what we write about today – price. Price is the most important evidence. It carries the most weight. We can have all the common and proprietary indicators in the world and they mean nothing without the confirmation of price. Below is a diagram so you can visualize what we’re saying.

12-02-2014 Just Look Left [weight of evidence, 6 of 7]

As you can see, we like to look for evidence to support our investment decisions. The best piece of evidence is price. What is it doing? What’s its direction? If price is making higher highs and higher lows, the trend is up. If price is making lower highs and lower lows, the trend is down. By analyzing price itself, we can determine the general trend and the potential change thereof. Using the diagram above, which shows the current status of the market, we can see that price moving to the right side of the scale would cause it to tip dramatically to the right into a new and potentially strong downtrend. In the same light, if the evidence on the right shifted to the left side of the scale, the swiftness of the uptrend would increase. So at this point in time, we are watching price like a hawk. How do we do this in reality? Simple. Just look left. When we analyze price using charts, we find the current price and look left. See the daily price chart of the S&P 500 below. Notice that price has been steadily making higher highs and higher lows. It is a beautiful staircase upwards, hallmarking an uptrending market. The exceptions are back in early February (SPX made a lower low and tested the trendline from the 2007 top) and back in mid-October (SPX made a lower low and tested previous highs/lows near 1825). Each time, the market recovered by subsequently making new higher highs without recording a lower high. When we consider this most important piece of evidence, the scale is easily tipped towards an uptrending market. All the other evidence only provides perspective in the event price changes and makes lower lows and lower highs. All the other evidence indicates caution is warranted. But, that doesn’t mean we need to short or be out of the market. Right now, price is telling us to remain long this market. As for the future, we’ll let price dictate what we should do next.

Look for our series finale on game planning and risk management soon.

12-02-2014 Just Look Left S&P [weight of evidence, 6 of 7]

Consumer Discretionary

Leader of the Pack [Weight of Evidence, Part 5…

November 20, 2014April 13, 2022

At 360 Investment Research, we like to dig deep into the market and take a look at what sectors are leading the US market upward. By analyzing sectors on a relative basis against the S&P 500, we can gain insight into what sectors are leading the charge. This, in turn, may provide clues on where we are in the market/economic cycle. The theoretical market/economic cycle is a model based on the work of Sam Stovall in his book, S&P’s Guide to Sector Rotation. The basic premise is that different sectors are stronger at different points in the economic cycle. StockCharts.com has done a great job elaborating on this rotational cycle. The chart below is courtesy of StockCharts.com. It does a good job of visualizing these relationships and the order in which each sector should outperform in the context of the overall market. Moving from left to right, we see that Cyclicals (or Consumer Discretionary) and Technology lead the market out of bottoms. Industrials, Basic Materials, and Energy lead during a Bull Market. And Staples, Healthcare, Utilities, and Finance are the safe havens during Bear Markets. It’s not as clear cut as what I just wrote or what is visualized below, but it is a really great guide to the likely relative performance characteristics of each sector as the market progresses.

Researching approximately how each sector is performing can be a good exercise in determining where we might be in the overall market cycle. Obviously, if we’re in a healthy Bull Market, we want to see Bull Market leaders like Technology, Industrials, Materials and Energy outperforming (or leading) the overall market. Conversely, we would be concerned about the overall prospects of the market and economy if we see that big money is moving into defensive sectors like Staples, Healthcare, and Utilities. So let’s dig in and see what sectors are leading the overall market.

One of the best ways of observing which sectors are doing the best and which sectors are lagging is through the use of Relative Rotation Graphs (RRG) [1]. RRG charts show us the relative strength and momentum for a group of stocks or ETFs. These stocks or ETFs are compared against a benchmark. In our case, we’re going to compare the aforementioned sectors using the overall market (the S&P 500) as our benchmark. That is to say, the performance of each of these sectors will be compared against the performance of the S&P 500. If a sector is outperforming the market, they are said to be the leaders. If a sector is underperforming the market, they are the laggards. On the RRG chart below, the following ETFs are being used as proxies for each sector:

XLY (Cyclicals or Consumer Discretionary)
XLK (Technology)
XLI (Industrials)
XLB (Materials)
XLE (Energy)
XLP (Staples)
XLV (Health Care)
XLU (Utilities)
XLF (Financials)

Of the ETFs above, those with strong relative strength and momentum in comparison to the S&P 500 appear in the green Leading quadrant. Those with relative momentum fading move into the yellow Weakening quadrant. If relative strength then fades, they move into the red Lagging quadrant. And when momentum starts to pick up again, they shift into the blue Improving quadrant. In the RRG below, the long tails represent the movement of each sector over the past 20 weeks in comparison to the S&P 500. So what do we see? We see that XLV, XLU, XLP, and XLF have moved from positions of weakness and laggards to positions of leadership. Health Care (XLV), Utilities (XLU), Staples (XLP), and Financials (XLF) – defensive sectors – are leading this market. On the other hand, Technology (XLK) is weakening while Energy (XLE), Materials (XLB), and Cyclicals (XLY) are lagging. Bluntly, defensive stocks are leading and those who we want to lead a Bull Market are lagging. Money is flowing into defensive sectors. This is not what a healthy and powerful Bull Market looks like. Does it mean that this the top of the Bull Market? No one knows that. But, enough money is flowing into defensive sectors that investors like you and me should take notice.

[1] Note: The terms “Relative Rotation Graph” and “RRG” are registered trademarks of RRG Research.

Tag: Sector Rotation

Want to Make Great Investment Decisions? Just Look Left.…

Leader of the Pack [Weight of Evidence, Part 5…