Sector Rotation in Today’s Market

05/22/2012 1:00 pm EST

Focus: STRATEGIES

Corey Rosenbloom

Founder and President, Afraid to Trade

As the economic cycle changes, so too should sector allocations, says Corey Rosenbloom, defining risk-on and risk-off sectors and how he uses technical analysis to spot key turning points.

I’m with Corey Rosenbloom. Tell us about how technical analysis works with sector rotation; how you look at it, and what you’ve seen works.

In terms of sector rotation, teachings from Sam Stovall, Peter Navarro, John Murphy, and Martin Pring are rooted in technical analysis of longer-term moves. And if we discuss sector rotation, we’re talking about economic cycles, and we divide the market terms of how we look on the charts to usually nine different sectors.

We’ll go through them all, but basically, we’ll break it in two different things: the aggressive, or offensive side, retail, financials (XLF), technology (XLK), etc.; and the conservative, or defensive side, which would be health care (XLV), staples (XLP), and utilities (XLU). 

So, if you break the market—the S&P and the Dow—into two different groups, those are the components, but it goes beyond that.

With the beginning of the economic cycle after a bear market or after a recession, as a market or as the economy is finding a bottom, usually interest rates are low and people have been saving. They have not been purchasing houses or cars, or larger investments. 

They begin to do that; the prices become cheap, and so they begin to take those cheaper houses and cars, etc. So we start to see these things in the charts of certain stocks; homebuilders, for example, and financial companies, as they are making more loans.

Then as the economy reflates and the cycle continues, we see companies repurchase or purchase new technologies, or reinvest, or they take replacements on their computers or infrastructure. They begin to see technology shares rise, infrastructure, and also consumer discretionary stocks, which would be homebuilders and gambling stocks, things like that.

Durable goods.

Like durable goods, exactly; retail.

Then as the cycle moves on (this takes years), it begins in material goods, industrial goods, finally peaking with inflation. Inflation, as the economy recovers, does pick up, too. Eventually there becomes a point where inflation has gone too high, so we look for the final cycle in energy, which would be oil or gas prices, especially in terms of consumers.

If gas prices get too high, people cut back, they stop spending, and as the markets are going too high, they’re sometimes overleveraged.

The market begins to show signs of peaking, and investments are going to rotate towards the more risk-off assets. That’s generally, in a very concise, quick manner, sector rotation and how it affects investors.

See also: Risk-on vs. Risk-off Trading

Where are we in that cycle?

I would say in the later economic expansion. We are seeing inflation; we’re seeing oil prices rise. We’ve been in a recovery since technically, I think, June 2009. The stock market bottomed March 2009, so we had a little bit of a lead, and the financials were not the ones to lead the market; they’ve been underperformers. 

That’s unusual, but what happened—a financial crisis—so there’s a little bit of an overriding factor. We have seen lots of overperformance in retail and technology. We’ve seen commodities rise over the last three years, and we’re probably towards the middle to late economic expansion.

What we would look for as a caution sign of potential danger would be energy and also inflation. We’re not quite seeing that yet, so things are still clear. Interest rates are at record lows; they’re very low, and inflation is, by the (Fed) chairman’s sense, not that much of a problem.

We would be looking for risk-on assets or aggressive sectors like, again, technology. I would focus our attention on technology, materials (XLB), industrials (XLI), with the warning sign being energy. Or, if we start to see any kind of strength on a longer-term basis in defensive sectors like health care, utilities, and consumer staples like Clorox (CLX) or things we purchase at all points in time.

We don’t always buy a house, a car, or clothes, but we’ll always buy toothpaste, so this is what we look at to segment it out and make our decisions.

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