5 secrets of Wall Street, Part 3: Sector Rotation

This “secret” may not be news to most experienced investors. We hear the phrases sector rotation and asset allocation from the mouths of money managers all the time, so we know it’s a big part of the business. It’s based on the idea, proven by over a century of data, that certain industry sectors perform better than others at different points in the economic business cycle, and therefore the stocks in those sectors should be bought at those points. Here’s a great snapshot of the idea from one of my favorite market data sites, StockCharts.com:

Note that the market cycle anticipates the economic one, which means that investment managers learn it’s better to be early than late. And this graphic doesn’t include the yield curve’s influence on the cycle, which they obviously are watching as well. Here is the quick and dirty summary of “which sectors to buy when” under this theory:

Recession Bottom: Cyclicals, Technology, Industrial

Early Recovery: Materials, Energy

Late Recovery: Staples, Services

Early Recession: Utilities, Financials

The early stage recovery is all about “offense” as companies are expected to boost capital spending and investment, and the late stages are for “defense” with consumer staples and utilities the preferred places to put money. Sectors not specifically mentioned here are healthcare, telecom, and consumer discretionary, which is definitely an early cyclical play and 2009 was no exception for these stocks despite the conventional wisdom that the consumer was dead after the wealth and credit destruction of 2008.

When I say that certain industry sectors “perform better,” I’m talking about corporate profits, not the stocks. But, if hundreds of billions in investment capital favors the stocks of certain industry sectors depending on where the economy is in the cycle, the resulting higher stock prices probably help create even more favorable environments for businesses to capitalize on the cycle, whether through financing leverage or acquisitions. In this way, sector rotation could become somewhat self-fulfilling.

Since this type of money movement is causing major shifts of equity capital as often as a few times a year—or as infrequently as every one-to-two years in an average four-to-five year cyclical growth phase—it pays to follow the philosophy. Sam Stovall, chief investment strategist for Standard and Poor’s, is the guru here with at least two books on the topic and a column in BusinessWeek called “Sector Watch.”

For a good primer on sector rotation, see Chris Stone’s article on Investopedia.

Stone includes this quote by Stovall:

“The National Bureau of Economic Research sets dates for peaks and troughs in economic activities, based on its assessment of such factors as gross domestic product and employment growth. Since 1945, the U.S. economy has experienced 11 recessions and 10 expansions (it’s now in our 11th expansion). Growth periods have lasted an average of nearly five years (59 months, to be exact), with the shortest being 12 months from July, 1980, to July, 1981, and the longest at 120 months from March, 1991, to March, 2001.”

Stovall’s data about the average life of growth periods being 59 months contradicts the factoid I threw out yesterday of 43 months. I’m not sure how that too-conservative figure got lodged in my head, but I’d go with Sam on this one. He’s got more economic number-crunching experience and capabilities than I ever will.

Below is a sample of a research product that S&P puts out weekly, which gives great snapshots of the major sectors they track in the form of Relative Strength Charts, with 39-week moving averages and the S&P 500 index as the baseline of performance (green line). It can be accessed for free on the SectorSPDR website.

Is the Sector Game Faster Now?

Sector rotation is definitely worth paying attention to because it’s part of the asset allocation strategies controlling lots of stock market money. Even if you don’t believe the economic cycle approach should be followed religiously, it still pays to know who might be doing what that moves the market.

What you probably notice is that these moves happen more often as hot hedge fund money chases quick returns, buying a sector one month and selling it the next. In a sell-off of a strong area, say energy or retail or biotech or commodity stocks, it’s easy to forget sometimes what’s really going on and that the longer-term sector idea may hold.

For example, we’ve seen dramatic moves in materials and “commodity” stocks in the past nine months, from basic mining products and precious metals to agriculture and fertilizer names. As stocks like Freeport-McMoRan (FCX) and Potash (POT) get traded back and forth in rising channels, you can get whipsawed trying to trade them.

But if you see the forest for the trees—the sector, not just the stock—you can better gauge what institutional money is doing. Financials have outperformed only because they were so battered in 2008, while energy has been a steady place to have money.

Materials and technology were market leaders in 2009 and this does not seem to be letting up yet. Steel stocks started getting upgraded by major investment houses and analysts last month as information channels saw the surging demand from China. U.S. Steel (X) made a huge move after it broke above $50. Admittedly, that was one I missed and would have jumped on for the chart alone had I been paying attention.

Money Flow Windows

Places you can get reliable data on sector rotation are scattered. The Standard and Poor’s charts above give you a solid idea of the longer-term trends. And its Web site always has earnings projections by sector if you want to compare those forward estimates to the current trend. If you are playing a short-term game, you really have to setup your own sector watch lists using ETFs and the top names in them so you can be ready to “buy the dips, and sell the rips.”

Two other sources that are invaluable for macro money flow data are TrimTabs.com, which publishes proprietary analysis by subscription (but even looking at the data that is over one month old is still helpful), and the Investment Company Institute at ICI.org. In addition to lots of free education about investing, they provide two data windows worth checking out:

These “money flow windows” can help you see what trends in market ocean currents are continuing, stalling, or reversing. One area in particular I am watching based on their data is the massive bond fund inflows of the last year and when they will start to reverse. For the second half of 2009, total bond fund inflows dwarfed total equity fund inflows $238.4 billion to minus $11.7 billion! The easy guess here is that when interest rates start to rise, this money will find its way into stocks. Where else can it go?

Finally, StockCharts.com has a terrific interactive tool for viewing the flows and returns of the nine major S&P sectors. It has a sliding scroll bar that lets you look at side-by-side performance of the nine SPDR ETFs in rolling 65-day periods going back four years. Try this tool today. If it doesn’t convince you of the power of sector rotation, nothing will!

Two days left in this five-part series on “secrets of the street.” I’m not sure which one I’m going to roll out tomorrow (I’ve got three in mind), but I’d love to hear from you about what you like so far and what you think should be discussed. Email me at KCook@ONN.tv and be sure to always…

“Mind the Risk, Bank the Profits!”

5 Secrets of Wall Street: Profiting from How Stuff Works

Secret One: They Have to Buy Stocks

Secret Two: They Don’t Have to Sell

Secret Four: Liquidity, Information, and Speed Rule

Secret Five: Risk management isn’t a science