Sector rotation is difficult to spot in real time because it unfolds over weeks or months and isn’t always obvious until after the fact. Since there’s no single or definitive way to monitor a rotation, you’d have to observe it from different angles. In this article, we’ll examine one combined approach you can use.
Tuesday’s Consumer Confidence report saw its worst decline in four years. This followed last week’s Consumer Sentiment report, which also caused a huge upset. If anything, these confidence reports indicate that investors are forecasting the likelihood of a recession.
Might these expectations also be evident in the way investors are allocating their capital? In other words, are we seeing an early sector rotation from cyclical to defensive stocks?
Julius de Kempenaer’s article on the top five leading sectors touches on this. If you’re not familiar with his articles, sector rotation is sort of his thing, so I recommend you follow his posts if this interests you.
FIGURE 1. RRG SECTOR CHART. Is a rotation underway?Chart source: “The Best Five Sectors #8.”Consumer Discretionary (XLY) and Financials (XLF)—both cyclical components—have begun to retreat from their leadership positions. Meanwhile, Utilities (XLU), a purely defensive sector, started showing signs of strength despite lagging behind its cyclical peers.
To get another bird’s eye view of sector activity, pull up a sector chart on MarketCarpets. Here’s a screenshot of a five-day view taken on Tuesday. It doesn’t show the type of movement the RRG chart shows, but you can view the strength of performance (and other available metrics) in percentage terms.
FIGURE 2. MARKETCARPETS SECTORS CHART. Among the cyclical stocks only, Consumer Discretionary is the weakest performer, while Consumer Staples leads the pack.Image source: StockCharts.com. For educational purposes.
Granted, five days of performance doesn’t define a trend, but this chart suggests an interesting pattern: Consumer Staples, Health Care, and Real Estate are outperforming their sector peers. Although Real Estate is generally cyclical, REITs, known for their steady income, often exhibit defensive characteristics.
What do these movements look like in terms of market breadth? The Bullish Percent Index (BPI) is a powerful tool for assessing the internal strength of an index or sector. So let’s examine the top three cyclical and defensive sectors to see what the BPI reveals.
FIGURE 3. THE TOP THREE CYCLICAL AND DEFENSIVE SECTORS BASED ON BPI.Chart source: StockChartsACP. For educational purposes.
While the BPI gives you the percentage of stocks exhibiting P&F buy signals (see the highlighted number on the vertical axis to the right), there are a lot of nuances involved in analyzing these numbers in detail. For example:
- BPI favors the bulls when above 50% (meaning more than 50% of stocks in the index are signaling P&F buys).
- BPI favors the bears when below 50%.
There’s more nuance to this, all of which is covered in the ChartSchool article (see link above Figure 3). That said, here are a few key points:
- The cyclical sectors—Consumer Discretionary, Financials, and Materials—are either declining or lagging behind their defensive counterparts.
- Consumer Staples, Health Care, and Utilities—all defensive sectors—have a greater percentage of stocks signaling P&F buy signals, a bullish indication.
It would help to compare the performance of both sector groups, which is why it’s a good idea to look at ratios.
Here’s the issue: Finding a definitive index for these stocks is challenging, since sectors like Tech, Industrials, Energy, and Communications fall somewhere between cyclical and defensive. However, ETFs such as the iShares MSCI USA Momentum Factor ETF (MTUM) and the Invesco S&P 500 Low Volatility ETF (SPLV) can serve as useful proxies for cyclical and defensive stocks, respectively.
- MTUM is heavily weighted in Technology, Consumer Discretionary, Industrials, and Financials stocks.
- SPLV is concentrated in Utilities, Consumer Staples, and Health Care.
Here’s a ratio chart (SPLV:MTUM) comparing the two.
FIGURE 4. RATIO OF SPLV TO MTUM. This attempts to show the spread between defensive vs cyclical sectors.Chart source: StockCharts.com. For educational purposes.
By plotting a Zig Zag line, you can see the swing points that define the ratio’s trend. Note the following:
- Defensive sectors appear to be basing, if not bottoming, against cyclicals, following a longer-term downtrend.
- Defensives have also broken above a recent swing high but appear to be pulling back; if a rotation were to occur, you’d expect the ratio to continue trading above both the current swing high and low, following the basic principle that an uptrend consists of consecutive swing highs and lows.
Your Next Action Steps
Keep tracking the activity of defensive and cyclical sectors using the RRG, MarketCarpets, BPIs, and ratio chart. It’s too early to tell right now whether a sustainable rotation is at play, and much of the dynamics affecting these sectors are subject to the political and geopolitical policies at play. If the likelihood of a rotation appears more evident, then drill down on sector ETFs or individual stocks within the sector.
At the Close
Sector analysis is a complex topic that requires a multi-angled approach. If you’re attempting to time a rotation, you don’t want to move too early into a rotation that doesn’t pan out, but neither do you want to move too late. By using StockCharts tools like RRG charts, MarketCarpets, BPIs, and ratio analysis, you can gain clearer insights into whether investors are shifting from one sector to another. Keep a close eye on economic and policy shifts as well, as they’re likely to change the conditions of the market.
Disclaimer: This blog is for educational purposes only and should not be construed as financial advice. The ideas and strategies should never be used without first assessing your own personal and financial situation, or without consulting a financial professional.
