At first blush, this week’s drop in global stock indices looks like just another pullback within the long-term uptrend.
And in all likelihood it is.
But the recent dip gives us the opportunity to delve into a potentially bearish development simmering beneath the surface of the stock market’s rally as we head into the meat of the Q2 earnings season.
Sector rotation is a method of examining stock markets that goes beyond traditional technical analysis. In essence, it involves looking at what types of stocks are performing well to help predict how the stock market as a whole will perform moving forward. Historically, economically-sensitive sectors like consumer cyclicals and industrial stocks tend to outperform the stock market in a healthy uptrend, while economically-insensitive sectors like utilities and health care stocks typically outperform when the market is at risk of a pullback. Sector rotation “works” because most money managers must maintain a full allocation to stocks, regardless of their outlook for future performance. Therefore, the best way for them to mitigate losses in a bear market is to move funds out of high-flying speculative equities and into more conservative, stodgy stocks.
John Murphy, the godfather of intermarket analysis, developed the idealized sector rotation model shown below:
_20140710153351.jpg "bearish sector rotation model")
Looking to today’s market, the sector performance in the S&P500 suggests that we may be entering the twilight of the stock market’s rally. The three strongest performing sectors this year have been Utilities, Energy, and Health Care, corresponding with the “Market Top” stage in the image above. Meanwhile, economically-sensitive sectors like Consumer Cyclicals, Financials, and Industrials have trailed the S&P500 thus far this year, suggesting concern with the sustainability of this year’s rally:
_20140710153500.png "performance chart")
Of course, sector rotation is just one way of looking the market, and most other forms of analysis including breadth, momentum, and even basic price analysis are still waving the “all clear” flag for bulls (though bullish sentiment is also reaching concerning levels). For now, a strategy of “skeptical participation” in the equity rally is still favored, but continued bearish sector rotation may prove to be a harbinger of the long-awaited correction in the S&P 500.
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