Sector analysis often reveals insightful information about the state of the economy, or at least investors’ perception of the economy. However, it can often be confusing because the stock-market cycle is out of phase with the economic cycle. We’ve all been told that the stock market is a discounting mechanism, but that does not mean it prices stocks at a discount to their true value. No, in this context, discounting means the market is already considering future economic events.
If you enter “sectors and economic cycles” into your favorite search engine, you will see numerous graphic examples of the economic cycle overlaid with the stock-market cycle. The charts segment the stock-market cycle into sectors and groups, showing which ones typically perform best during various phases of the economic cycle. They make it all look so easy and academic.
While visually appealing, there are many obstacles with using these charts to time your sector buy and sell signals. The first problem is obvious to any investor that has been through a complete cycle: the stock market and the economy never move as smoothly and predictably as illustrated. Another hurdle is that many of these charts do not agree with each other. In other words, many of the actors are reading from different scripts.
There are also many instances of sectors going off-script, going rogue, or otherwise not behaving as expected. Early 2016 was a good example. The market was declining, and the script called for “defensive” sectors to take the leadership. Historically, that would mean Utilities, Consumer Staples, and Health Care would be the top performers. However, Health Care was at the other end of the performance spectrum this time around.
Another major obstacle is the discounting nature of the market as discussed above. Because of this, an investor cannot determine which sectors to buy and sell based on the state of the economy, because the economy will not be in that state for another six to 12 months. You can try to predict where the economy will be in the future, but keep in mind that many professional economists have a poor record of doing that.
Instead of using these charts to let the state of the economy generate sector buy and sell signals, the typical usage has been just the opposite: using current sector strength and weakness help decipher where we are in the economic cycle. It’s the classic chicken-and-egg conundrum, but when it comes to this subject matter, sector rotation usually occurs first.
I tend to have my own sector groupings and definitions. You’ve probably heard me refer to the “defensive trio” of Utilities, Consumer Staples, and Health Care many times. These three sectors typically produce the best relative strength during times of market weakness. As shown above, this is not always the case. Additionally, the high-dividend yields found in the Real Estate and Telecom sectors often allow them to be included in the defensive group.
“High growth” is another mode or sector grouping I use. As you probably expect, Technology is the primary member of this group. Strength in Consumer Discretionary is also usually evident when the market is in this mode. The late 1990s was a great example, and the explosive Technology sector growth of that period produced outsized gains for Health Care and Telecommunications—two sectors mentioned above as belonging to the defensive group.
This week, our intermediate-term sector rankings suggest the market is now in what I refer to as “smokestack mode.” Basic Materials, Energy, and Industrials are the sectors comprising this group. Analysts often refer to these three as the sectors representing the old economy, the manufacturing economy, or the smokestack economy. They represent the basic ingredients of a growing industrial base including raw materials, fuel, transportation, and manufacturing. Analysts have suggested that the oil production boom in the U.S. of the past few years could lead to a resurgence of U.S. manufacturing strength, and perhaps we are now seeing the early signs of that.
If the market is indeed shifting from defensive to smokestack mode, then it is one more reason not to let sector and economic-cycle charts guide your investments. Most of them say that strength in Energy and Materials occurs immediately before strength in Utilities and Consumer Staples—not afterward as current evidence suggests is now happening. Instead, let the market be your guide.
The sector rankings are displaying significant changes in leadership this week. Materials rose to the top a week ago and continues to occupy that position today. Energy, which was on the bottom just two weeks ago, climbed three more rungs of the ladder to land in second place. Materials and Energy are currently displaying much larger momentum scores than the other sectors, providing them with a significant advantage. Industrials jumped four places higher to grab the third spot, completing the smokestack mode of sector strength described above. The defensive mode sectors have all moved to the lower half. Utilities dropped three places to sixth, Health Care held steady in tenth, and Consumer Staples plunged from sixth to last. However, Consumer Staples is still sporting a momentum score of 20, so being last does not equate to being in danger at this time. It means it is moving up, but it is doing so at a slower pace than the other sectors. Other notable changes include the fall of Real Estate from second to fifth, the two-notch improvement for Consumer Discretionary, and the three-place jump out of last place for Financials.
All style categories gained strength, and since the lowest-ranked style has a momentum score of 24, it signifies a currently strong and healthy market. Except for Mid-Cap Value, which held on to its first-place ranking for a seventh week, all of the other categories changed positions. Upside movers included the five-spot jumps of Small-Cap Value to second, Small-Cap Blend to fourth, and Micro-Cap from last to sixth. It was a show of strength for the smaller capitalization segments as even Small-Cap Growth managed a two-place climb. Therefore, it was the Large-Cap categories giving up the most relative-strength ground. Large-Cap Growth plunged from third to last, although it actually boosted its momentum in the process. Mega-Cap dropped five places to ninth, and Large-Cap Blend slipped two spots lower.
Changes to the global rankings were minimal compared to sectors and styles, although a similar theme is evident. Latin America and Canada are occupying the top-two spots for an eighth week. Today, Pacific ex-Japan joins them in third place. The common denominator across these three categories is that they are all physically large and rich in natural resources. In fact, this group is known by the acronym ABC, which stands for Australia, Brazil (the largest economy and land mass in Latin America), and Canada. They are the global regions you would expect to be on top when Materials is the strongest sector. The U.S. and the U.K. had the largest declines in relative strength despite gaining absolute strength. The U.S. posted a 10-point increase in momentum, and the U.K. outdid that with an 18-point jump of its own. However, they both fell three spots, with the U.S. now in seventh and the U.K. dropping to last. Japan was the lone category remaining in the red last week. Its huge 27-point jump in momentum put an end to that and allowed Japan to move two places out of the basement.
“If you’re in the right sector at the right time, you can make a lot of money very fast.”
— Peter Lynch (1993)
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