market rotation: two types

market/sector rotation

Market rotation, sometimes also called sector rotation, is a shift in the pattern of sector outperformance in the stock market.  In 2016, for example, the S&P 500 favored defensive sectors over aggressive ones.  2016 produced the opposite result.

why

The market rotates for two basic reasons:

change in economic circumstances.  In early 2016, for example, Wall Street began to believe that the price of crude oil, which had been in free fall for two years, finally hit bottom at around $26 a barrel.  So oil stocks began doing better.  Similarly, investors now believe that the election of Donald Trump as president, meaning both houses of Congress and the White House are all Republican, signals the end of Washington dysfunction.  This implies a significant turn for the better in the US economy.  As a result, the most economically sensitive areas of the stock market have been doing better since Election Day.

valuation.  Professional investors often say that “trees don’t grow to the sky,” meaning that at some point sectors that are enjoying an economic tailwind become too expensive relative to those being buffeted by temporary headwinds.  At such times, they will begin to buy stocks in left-behind sectors almost entirely on the idea that as financial instruments they are relative bargains.

short/shallow vs. long/deep

Sector rotations based on valuation tend to be much shorter and shallower than those based on a change in economic circumstances.

the 2015 -16 example

In 2015,  the Healthcare sector rose by +5.2% and Energy fell by -23.6%.  The difference in performance between the two was a whopping 28.8 percentage points.

In 2016, Healthcare fell by 4.4% and Energy rose by +23.7%.  The performance difference between the two was 28.1 points.

what about today?

To me, the extent of the outperformance of the most economically sensitive sectors since the election has been so strong as to invite a market rotation away from them.  My guess is that this will be based mostly on relative valuation.  If so, the turn away from current market leaders will be relatively brief and the correction in these sectors relatively shallow.

For day traders, this will be a big deal; for you and me, not so much.  Our main concern will be the buying opportunity in cyclicals a correction in them will present.

entering 2016…

Three thoughts:

–taxable investors sell losers in December, winners in January

This has something to do with strategy, as investors reshape their portfolios for the new year.  But it’s more about recognizing losses to count against this year’s income while nursing gains into the new year for sale so income tax on them is delayed.

As a result of tax-selling distortions, the first couple of weeks in January march to their own drummer.  Losers beaten down by tax selling rebound (more about this and the “January effect” in a few days); last year’s winners swoon for a short time.

Early January often presents an opportunity to buy interesting stocks a bit cheaper than otherwise.

–dividend stocks

If I’m correct that 2016 will be another so-so year for stocks–let’s say up 5% or so–then stocks with an above-average dividend yield should remain attractive.  Since they’re typically mature firms with more reliable income streams, they also provide some downside protection.

The current dividend yield on the S&P 500 is 2.04%.  I think anything 50 basis points or more above that is worth a second look.  This is one reason I’m holding on to Intel (-2.3% ytd in 2015) and Microsoft (+21.7%).

–sector rotation?

The year to date returns on the S&P sectors are something like this:

Consumer discretionary     +10.5%

Healthcare          +7.5%

IT          +7%

Utilities          -4%

Materials          -7%

Energy          -19%.

One could easily argue, purely on mechanical grounds, that the 30% difference in performance between Consumer discretionary and Energy merits at least some rebalancing away from the first toward the second in an active portfolio.

I’m not ready to to this quite yet.  I’d like to see yearend financials first.  But the numbers argue that we’re getting close to the time to act.