CHART 22.4 S&P Composite versus Amex Brokers Index, 1978–2012
The key point that I am leading up to is that if the economy goes through a rotational process starting with housing and ending with capital spending, the same thing should be true of the various stock sectors, each of which is discounting its own portion of “the” economy—hence, the sector rotation process. As we examine the various sectors, two things will become evident. The first is that there is a definite order to the way things can be expected to unfold as the cycle progresses. Second, while this is true most of the time, there are enough exceptions to keep us on our toes. These exceptions most often develop because of special circumstances that specific industries may be going through that change the way in which that particular stock sector fits into the normal business cycle progression.
Since the majority of stocks are rallying most of the time during a bull market, it follows that most record their bear market lows about the same time as the averages. When utilities are described here as a leading group and steels as a lagging group, the implication is not necessarily that utilities reach their lows ahead of the low in the S&P Composite, although they do in most instances. What is more likely to happen is that utilities, being interest-sensitive, will put on their best performance relative to the market around the beginning of the cycle. Similarly, steels might advance with the averages during the early stages of the bull market, but their best relative performance has a tendency to occur during the later stages of a bull market or the early phases of a bear market. Notice that I have emphasized the word “tendency” because that is really what we are talking about—tendencies and probabilities, never certainties.
The overall market consists of sectors, which are a reflection of the companies making up the various segments of the economy. The economy, as defined by an aggregate measure, such as gross domestic product (GDP), is either rising or falling at any given time. However, there are very few periods in which all segments advance or decline simultaneously. This is because the economy is not one homogeneous unit, but an aggregate of a number of different parts. Some industries respond better to deflationary conditions and the early stages of the productive cycle; others are more prosperous under inflationary conditions, which predominate at the tail end of the business cycle.
Major Technical Principle The stock market discounts the economy, but stock sectors discount their sector of the economy. Since the economy experiences a set series of economic events, so, too, do stock sectors. The process is called sector rotation.
Economic recoveries are typically led by consumer spending, which is spearheaded by the housing industry. As interest rates fall during a recession, demand for housing gradually picks up. Hence, home building and some building and construction stocks can be considered leading groups. In the same way, the lumber price, a key housing ingredient, has had a consistent (though not perfect) record of leading industrial commodity prices in general.
Because they anticipate a consumer spending improvement, retail stores, restaurants, cosmetics, tobacco, and so forth also show leading tendencies, as do certain interest-sensitive areas, such as telephone and electric utilities, insurance, savings and loans, and consumer finance companies. As the recovery continues, inventories, which were cut dramatically during the recession, become depleted. Manufacturing industry groups, which might be classified as coincident, then respond by improving in price or relative strength (RS). Finally, as manufacturing productive capacity is used up during the last stages of the recovery, these companies seek to expand by investing in new plant and equipment. Consequently, stock groups associated with capital spending, such as steels, some chemicals, and mines, have a tendency to then emerge as market leaders.
Confidence is another influence on the group rotation cycle. During the initial stage of a bull market, emphasis is placed on prudence because investors have lost a considerable amount of money and the news is usually very bad. Stocks with good balance sheets and high yields begin a period of superior RS. As the cycle progresses, stock prices rise, the news gets better, and confidence improves. Eventually, the rotation turns to more speculative issues of little intrinsic value. Even though the peak in speculative issues usually leads that of the major averages, their most rapid and volatile period of advance typically occurs in the final or third leg of a bull market.
Some groups are not readily classifiable in terms of the productive process. Air transport, which goes through sharp cyclical swings, is a case in point. This industry average either coincides with or lags slightly at bear market lows, but is almost always one of the first groups to turn down before a peak. This could be because these companies are sensitive to interest rates and energy prices, both of which have a tendency to rise at the end of the business cycle. Drug stocks as a group, on the other hand, have a distinct tendency to present their best relative performance at the tail end of the bull market and in this respect should be regarded as a lagging group. They are likely also to lag in terms of RS at market bottoms, although this tendency is far less pronounced than their tendency to lag at market tops.
It is also worth noting that the sector rotation process has a tendency to work during intermediate-term rallies and reactions as well as primary ones.
What Are Sectors and Industry Groups?
When we talk of sectors, we are referring to broad categories of equities that contain a number of individual industry groups. Each sector is, in turn, broken down into industry groups. There are 10 or 11 generally accepted sectors, depending on your point of view, and 80-plus industry groups. The following list of sectors is arranged in rough proximity to their performance around the business cycle, starting with utilities, an early leader, through to energy. The word “rough” has been italicized because the cycle rarely, if ever, unfolds in exactly the manner expected.
Sectors
Utilities
Financials
Transportation
Telecommunications
Consumer Staples (nondurables)
Consumer Discretionary (durables)
Health Care
Technology
Industrials
Materials
Energy
This list of sectors is based on the Dow Jones methodology. S&P, an alternative provider categorizes transports, a leading sector, under the “industrial” (lagging) banner.
If we take the Utility sector, examples of individual industry groups would include electric, gas, and water utilities. Technology embraces, among other things, semiconductor manufacturers, software companies, Internet companies, electronic instruments, and so forth.
Sector Rotation and Global Equity Markets
In this book, we are principally concerned with the United States. However, it is helpful to know that as the world becomes a smaller place with greater corporate integration, the interaction between companies engaged in the same industry in different parts of the globe is also becoming closer. Thus, when the chemical industry is doing well in the United States, it is also usually prospering in Europe. The only reason why these two regional sectors would act differently would be due to currency changes and discrepancies in local laws, costs, or economic conditions.
In this respect, Chart 22.5 compares the relative strength momentum of the metals sector for the United States and India. It is certainly not a tick-by-tick perfect correlation, but it is fairly evident that when metals are doing well or poorly compared to the Indian market (The Nifty), metals in the United States, for the most part, are moving in a similar way.
CHART 22.5 Relative Momentum of S&P Metals versus BSE Metals, 2006–2008
There is a growing base of international-sector exchange-traded funds (ETFs) being listed by such sponsors as Global X and Guggenheim that adds to the plethora of issues already established using the Dow Jones and S&P tracking indexes. The S&P also has a family of global-sector ETFs that add some diversification, although most of them have a predominant weighting in U.S. companies.
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bsp; Splitting the Cycle into Inflationary and Deflationary Parts
Putting the group rotation theory into practice is not an easy matter because the character of each cycle is different. In a rough sense, the business cycle can be split into a deflationary part and an inflationary part. A useful starting point is to obtain an inflation/deflation indicator in order to determine that a falling trend in this indicator is deflationary and a rising one inflationary.
One way would be to compare the price of a specific deflation-sensitive stock, such as a utility, with an inflation-sensitive one, such as a mining company. The problem with this approach is that one of them may be affected by internal conditions totally unrelated to the business cycle. The same drawback might be true of a comparison of two industry groups, such as utilities versus gold. For instance, the utility group could be suffering from aggressive government regulation, whereas the gold group may be unduly stimulated because of a mining strike in South Africa. Neither event would be associated with the business cycle, but both would strongly influence the trend and level of an inflation/deflation ratio.
A better solution is obtained by constructing an inflation indicator from several inflation-sensitive groups and a deflation indicator from deflation-sensitive industry indexes. Thus, if one particular industry is influenced by noncyclical forces, it will not unduly distort the total result. A comparison of an inflation- and deflation-sensitive index of S&P groups does not tell us a lot. However, when a ratio is constructed between them, a very useful inflation/deflation gauge is returned.
The Inflation Group Index is constructed from a simple average of the S&P Gold, Domestic Oil, Miscellaneous Metal, and Aluminum, and the Deflation Group Index from Electric Utilities, Banks, and Property and Casualty Companies.
Chart 22.6 shows the ratio and its KST as well as the KST of the ultimate inflation/deflation indicator: the commodity (CRB Spot Raw Industrials) bond (Barclays 20+ Government Bond ETF, symbol TLT) ratio. The important thing to notice is the closeness of their trajectories, yet they are constructed from totally different components. At one glance, you can appreciate how the internals of the stock market reflect inflationary and deflationary forces as they unfold in a typical business cycle. Unfortunately, we do not have a consistent established leader, as both KSTs alternate in that role.
CHART 22.6 Inflation/Deflation Ratio versus Two Momentum Series, 1959–2012
Chart 22.7 takes this a step further by comparing trends in the inflation/deflation ratio to that of industrial commodity prices. These series do not move in exactly the same direction all the time, but there is a definite correlation between them. The arrows show those periods when the 18-month rate of change (ROC) of the ratio moves above the +50 percent level and either crosses below its moving average (MA) or the overbought zone, whichever comes first. As you can see, they generally offer great sell signals for the commodity index, but even more timely ones for the ratio itself. The relationship is so consistent that when a sell signal is triggered, the odds of a new cyclical trend favoring deflation-sensitive equities are extremely high.
CHART 22.7 Inflation/Deflation Ratio versus CRB Spot Raw Industrials, 1971–2012
Before we leave the inflation/deflation relationship, it is worth pointing out that there is a simpler way to achieve an inflation/deflation ratio, and that is to divide the Goldman Sachs Natural Resource by the Spider Consumer Staples ETF, or the IGE by the XLP. The IGE is our proxy for inflation-sensitive areas, and the defensive XLP is our proxy for early cycle leaders. Chart 22.8 shows that the trajectories of the two series are reasonably similar. The disadvantage is that the history of their relationship only goes back to the turn of the century, compared to several decades for the original inflation/deflation ratio.
CHART 22.8 IGE/XLP Ratio versus the Inflation/Deflation Ratio, 2002–2012
Relative Paths of Leading and Lagging Groups Usually Diverge
Chart 22.9 shows the relationship between financials, a leading sector, and computers, a lagging one. Some observers believe that technology is a leading sector. However, this chart and research presented in The Investor’s Guide to Asset Allocation (McGraw-Hill, 2006) shows that it has a tendency to lag. That point can be appreciated from the chart because both series diverge in their trajectories, offering different opportunities at different times. You can see how, during the last couple of years of the 1982–2000 secular bull market, financials underperformed greatly because of the tech leadership. During the first year or so of the ensuing bear market, these roles were reversed.
CHART 22.9 Computer versus Financial Relative Sector Momentum, 1986–2012
Chart 22.10 features the relative long-term KST for the financials in order to demonstrate that when they are outperforming the S&P, the market is usually rising. These periods have been flagged by the shaded areas. Note the one exception developed during parts of the 2000–2002 bear market.
CHART 22.10 S&P Composite versus Financial Sector Relative Momentum, 1981–2012
Leading, Middle, and Lagging Groups
Finally, you may be under the impression that all inflation- or deflation-sensitive sectors move in tandem, but that is not the case. In this respect, Chart 22.11 features the relative long-term KST for lagging sectors—gold, metals, mining, and energy. Some of the time they do move in tandem, but there are a lot of situations when one or more of them do not. The point here is that when other indicators are demonstrating that the cycle has reached an inflationary phase, it’s important to check individual sectors or industry groups to make sure that they are acting in sympathy with the macro environment.
CHART 22.11 Selected Lagging Group Relative Momentum, 1995–2012
Bearing that in mind, the following table offers a very rough approximation of where a particular industry group falls within the cycle. It is important to bear in mind that not all groups neatly fit into these categories and not all those categorized will necessarily “work” in each cycle.
Leading (Liquidity Driven)
Utilities
Electric
Telephone
Natural Gas
Financials
Brokers
Banks
Insurance Companies
S&L’s
REITs
Homebuilders
Containers and Packaging
Consumer Nondurables
Beverages
Household Goods and Housewares
Tobacco
Personal Care
Foods
Restaurants
footwear
Textile Manufacturers
Transports
Middle
Retailers
Manufacturers
Health Care
Consumer Durables
Autos and Parts
Furniture and Appliances
Building Materials
Containers Metal and Glass
Leisure and Entertainment
Hotels
Waste Management
Airlines
Truckers
Railroads
Air Freight
Late Cycle leaders (Earnings Driven)
Energy
Oil
Coal
Drillers
Mining
Basic Industry
Papers
Chemicals
Steels
Heavy Machinery
Most Technology
Computer Manufacturers
Electronics
Semiconductors
Summary
1. The stock market cycle experiences a distinct pattern of sector rotation because of the chronological nature of the business cycle. Interest-sensitive groups have a tendency to lead at peaks and troughs. Corporations, whose profits are enhanced by increases in capital spending or commodity price inflation, generally lag the overall market.
2. Sometimes significant changes in the fundamentals of an industry will cause a group to be uncharacteristically strong or weak
during a specific cycle. Therefore, it is better to monitor a spectrum of groups rather than a specific one as a proxy for the rotation process.
3. An understanding of the industry group rotation cycle is helpful both in assessing the maturity of a primary trend and for the purpose of stock selection.
4. In a broad sense, it is possible to divide equity market sectors into inflation and deflation beneficiaries.
5. Sector rotation is not limited to the United States, but is a global concept.
23 TIME: ANALYZING SECULAR TRENDS FOR STOCKS, BONDS, AND COMMODITIES
Our discussion of these long-term trends will begin with a quick review of the Kondratieff long wave, later moving on to consider what constitutes secular trends and how they come about. Finally, it will be helpful to look at some ways by which we can identify reversals in this all-important price movement.
Major Technical Principle Secular trends exist for bonds, stocks, and commodities and average 15 to 20 years, sometimes longer but rarely shorter.
The Long (Kondratieff) Wave
In the 1970s, a school of thought (this author included) rationalized long-term trends in equity prices through an explanation of the Kondratieff wave. Nikolai Kondratieff, a Russian economist, observed that the U.S. economy had undergone three complete waves between its inception and the time he made his study in the 1920s. Interestingly, E. H. Phelps Brown and Sheila Hopkins of the London School of Economics wrote about the recurrence of a regular 50- to 52-year cycle in UK wheat prices between 1271 and 1954.
Technical Analysis Explained Page 32
