I routinely review the performance of each of the ten Standard &Poor’s Global Industry Classification Standards (GICS) Sectors vs. that of the S&P 500. This exercise allows for the identification of current sector-level performance trends. Additionally though, I assess the extent to which existing performance trends appear likely to persist of reverse. Right now, this work validates my perspective that equity markets are due for a multi-month correction or consolidation phase. During this period, I (more-or-less) expect the traditionally defensive sectors to outperform. My sector level analysis highlights the Energy sector as the beta play with the best forward prospects right now (over Industrials and Materials, for instance).
Historically, when broad equity indices decline, the most cyclical cohorts tend to fare worst and defensive sectors generally outperform (i.e. fall less). Exhibit 1 below demonstrates this phenomenon graphically. Notice that as the S&P 500 Index (shown in the upper pane of the chart) declined off its 2007 high, the series in the bottom panel actually advanced. This lower pane, which shows the performance of the S&P 500 Consumer Staples Sector Index vs. the S&P 500 Consumer Discretionary Sector Index, serves as a poor man’s comparison of defensive and cyclical equity performance. When the Staples/Discretionary series rises, Consumer Staples are outperforming Consumer Discretionary stocks (i.e. defensives are besting cyclicals), and vice versa. Observe that starting in 2009, as the S&P 500 began to run, the performance of defensives relative to cyclicals rolled over. Equity market strength in the years the followed corresponded with a poor showing for the Staples vs. Discretionary series.
A review of relative strength and momentum across GICS sectors reveals that since early- to mid-February, Telecommunications Services, Consumer Staples and Utilities are have each delivered superior returns versus the broader market. I expect these trends to persist for several months as weekly Coppock Guides for these defensive areas look ripe to inflect from deteriorating to improving over the course of the next one to three weeks. Typically, improving intermediate degree momentum supports prices (or in this case, relative prices) for 11-14 weeks, though it is not unusual for cycles to get stretched–especially in environment’s prone to governmental manipulation (as is currently the case). The weekly relative strength charts for the four GICS sectors on the brink of positive inflection, along with Coppock (Momentum) Guides are shown below. These areas represent my preferred focal points for equity portfolio exposure.
In contrast to Health Care, the highly cyclical Energy sector did manage to make the cut for preferred equity exposures. The promise of intermediate-degree outperformance from Energy likely owes to supply concerns that naturally emanate from mounting tensions with Iran over the nation’s nuclear ambitions. While it seems clear that the U.S and Europe favor the more diplomatic approach (economic sanctions), Israel, on the other hand, has alluded to the possibility of a pre-emptive strike to hinder Iranian efforts to achieve nuclear capabilities. Per KT McFarland, National Security Analyst at Fox News, there are three primary factors likely to influence Israel’s decision to take solitary action against Iran: the first issue relates to how much time Prime Minister Netanhayu feels he owes President Obama to run his diplomatic playbook. The second aspect pertains to the amount of time Iran requires to move its nuclear program deep underground—so that the operations are out of the range of Israeli weapons. The final consideration involves the timing of the coming U.S. Presidential election. The underlying concern being that while pledges of American support to the Israeli cause appear politically expedient leading up to the election (as candidates try to attract U.S. voters that have an affinity for Israel), the idea of involvement in another war in the Middle East is probably quite off-putting to the American public at large. Thus, promises of American backing of Israel’s efforts to curtail Iranian progress toward nuclear weapons may not hold past November (see a href=”http://www.foxnews.com/opinion/2012/03/08/israel-united-states-and-iran-in-dance-destiny/”>“Israel, the United States and Iran – locked in the dance of destiny” for McFarland’s full report). At any rate, my technical studies suggests this stress is unlikely to abate over the near-term. In fact, Exhibit 5 above shows a positive divergence between relative price and momentum (momentum made a higher high in January than was registered at the preceding peak last August, while relative price made a lower high). This condition offers another piece of evidence suggesting that the coming move higher in Energy prices vs. the S&P 500 will be quite strong.
For the record, I am not a perma-bear. I am not even necessarily bearish for this year. In fact, I think that at some point during the summer months of 2012, equities will afford investors opportunities for attractive, low-risk entry points. However, at the present juncture, I perceive enough technical and fundamental warning signs present to warrant caution toward equities. Specifically, commodity price weakness implies that margin pressures continue to mount (it has been demonstrated that changes in corporate margins are directly correlated with commodity price changes). Also, I perceive there to be room for corporate spreads to worsen into the summer. The empirical link between changes in spreads and equity performance is also well documented. Add to this that earnings estimates (on a global basis) continue to be ratcheted down (though the pace of downgrades has diminished significantly in recent weeks), intermediate-term sentiment is extremely overbought, valuations do not look not compelling, and positive surprise at the macro level appears quite unlikely given the beats realized in recent weeks and months (and resulting increase in expectations), and the result seems to be an unfavorable risk/reward tradeoff for investors.
As haze related to the aforementioned issues begins to abate (which I expect will correspond with declining equity prices), I will reevaluate my perspective. For the time being though, I am content to market-weight equities with a decidedly bias in favor of Telecom, Utilities, Staples and Energy.
Until next time, be nimble and trade safe!