Sector Rotation: A Sign of Good Health

Posted On May 4, 2018 12:48 pm

Once again, the major indices have held important support levels and are enjoying solid rebound. While many people believe the churning within the recent range will ultimately resolve with a larger move down to new lows, others see the price action a healthy sector rotation which will lead to renewed rally.

Market technician J.C. Parets makes the case for the latter here:

It’s hard for a mechanic to tell you what’s wrong with your car without lifting the hood to see what’s inside. In the stock market it’s no different. We often hear people giving a diagnoses of the market’s health simply by using the S&P 500 or some other popular index. To me, that’s irresponsible. This is not a stock market, it’s a “market of stocks”. There are 500 stocks in the S&P 500. The market is not a thing, it’s a lot of things.

Sector rotation is the lifeblood of any bull market. Some sectors are indicators of risk appetite while others point to risk aversion. Consumer Discretionary stocks include companies where we spend our discretionary income: retailers, homebuilders and autos for example. Consumer Staples, on the other hand, consist of companies that consumers would use regardless of whether times are good or bad. No matter how the economy is doing, we’re still going to drink beer, smoke cigarettes, brush our teeth, wash our dishes and clean our clothes. These types of companies are the Staples.

If you’re a buy side long-only manager, you can’t short stocks and you can’t go to cash. The mandates of these mutual funds require managers to be long at all times. It’s the PM’s job to outperform the benchmark. Not necessarily to make money, just to outperform. The way they outperform in a bull market is to overweight Consumer Discretionary stocks relative to Staples. When stocks are falling, one way they beat their benchmarks is to overweight Staples over Discretionary.

This doesn’t happen overnight either. Think of it like a cruise ship. It takes a long time for it to do a 180 and turn around. By observing this rotation, it is obvious what the ship is doing. We treat the market the same way.

 Related: This Industry is Ripe for Disruption – Here’s What This Means For You. 

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.