Sector Relativity

Portfolio managers tend to rotate money from some sectors to others depending upon what stage we are at in the economic cycle. The trick, obviously, is knowing where you are at in the cycle and how long that dynamic will continue.

This article was originally published by Zacks.com.

As the economy rolls through its much-anticipated waves of expansion and contraction, portfolio managers tend to rotate money from some sectors to others depending upon what stage we are at in the cycle. The trick, obviously, is knowing where you are at in the cycle and how long that dynamic will continue before evolving into another stage.

In an article Monday morning, The Economist addressed the length of the current recovery since the June 2009 recession trough at 42 months and whether or not job growth would have a chance to really get rolling before the expansion ended. The magazine noted that since the end of World War II, the average expansion has lasted 58 months, with the longest being the decade from 1991 to 2001.

Since the 2001 to 2007 expansion is the fourth longest at 73 months, it seems the odds are slightly in our favor for this one to run a bit longer than 42 months. You would not think so if you simply listened to the Economic Cycle Research Institute, whose analysis concludes that our economy has been in recession for over six months already.

But what if the behavior of institutional investors could predict the next recession better? We all know the cliché here that the market has successfully predicted nine of the last five recessions. And the past three years of market corrections are proof of that.

Still, even if money rotating between sectors en masse isn't a good predictor of recession, it may still provide good swing trading opportunities. Below is the classic diagram of sector rotation within the economic cycle, as often touted by Sam Stovall of Standard & Poors.

One important theme that this analysis offers us is that while any given bull market and its associated economic expansion are definitely connected and feed off of each other, they are not necessarily tied at the hip.

In other words, we know that the bear market often bottoms before the recession does and the bull market can put in a top before the recovery peaks.

Another thing to keep in mind is that the cycle and sector rotation model is just that a rough guide to how the cycles tend to work, not a mechanical blueprint. As my colleague Kevin Matras reminds us...

"Each recession and recovery can look a bit different however with its own unique set of characteristics.

The most distinguishing thing from this bull market recovery and previous ones was the absenteeism of the housing market. That seems fitting given it was the imploding housing market that essentially caused the financial crisis and ensuing recession in the first place.

Unlike previous recoveries, the housing market was slow to respond this time around. And that, in turn, helped keep the economy growing at only 2-2.5% on average, rather than the more typical 4-5% as in recoveries past."

What else makes this recovery and bull market completely unique? Unprecedented monetary stimulus and record low interest rates for as far as the eye can see.

The arguments in favor of this bull cycle continuing and avoiding recession are numerous:

Housing resurgence

Resilient consumer

Record corporate profits and cash reserves

QE Infinity

Low interest rates and low inflation

Technological innovation

Energy independence

Health care boom

China soft landing and new regime leaning toward stimulus

Steady growth that avoids boom-bust extremes (less excess = more shallow contractions)

The last idea is another conclusion from Kevin Matras.

Given this backdrop, I want to look at specific sector-and-index relationships to see if we can get some clues about the market's next moves. My assumption is that while it may be too difficult to figure out if the economy is poised to give corporate earnings a boost or a hiccup, we can at least follow trends in sector money flow to time our trades for the next quarter.

Relationship 1: Staples vs. Discretionary

Below is a three-year weekly chart that plots a ratio of two sector ETFs against the S&P 500. The black and red line is the ratio of the SPDR Consumer Staples ETF (XLP) over the SPDR Consumer Discretionary ETF (XLY).

The ratio line is black when Staples are rising relative to Discretionary, and it is red when the ratio is falling. Plotted behind is the corresponding movement of the broad index.

One thing that jumps out immediately is that when the broad market is headed into a correction, money pours into Staples at the expense of Discretionary. And when the market bottoms and turns upward, money flows the other way out of safety and into economically sensitive consumer areas.

As 2013 gets rolling, the ratio is below both troughs of 2012 and is flirting with levels not seen since the bull run tops of 2011. Note that all three of those prior lows were fairly solid indicators for a market turn lower. Now this may be merely a coincident indicator and not necessarily predictive.

But even for short-term swings in economic sentiment, it seems to make sense that money could move this quickly from safety to risk, and back, if there are genuine market concerns about a contraction.

Read the rest of the relationships here.

Kevin Cook is a Senior Stock Strategist with Zacks.com

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