Sector rotation (July 2014)

Sector rotation is a method of examining stock markets that goes beyond traditional technical analysis. In essence, it involves looking at what types of stocks are performing well to help predict how the stock market as a whole will perform moving forward. Historically, economically-sensitive sectors like consumer cyclicals and industrial stocks tend to outperform the stock market in a healthy uptrend, while economically-insensitive sectors like utilities and health care stocks typically outperform when the market is at risk of a pullback.

Sector rotation “works” because most money managers must maintain a full allocation to stocks, regardless of their outlook for future performance. Therefore, the best way for them to mitigate losses in a bear market is to move funds out of high-flying speculative equities and into more conservative, stodgy stocks.

John Murphy, the godfather of intermarket analysis, developed the idealized sector rotation model shown below:

Looking to today’s market, the sector performance in the S&P 500 suggests that we may be entering the twilight of the stock market’s rally. The three strongest performing sectors this year have been Utilities, Energy, and Health Care, corresponding with the “Market Top” stage in the image above. Meanwhile, economically-sensitive sectors like Consumer Cyclicals, Financials, and Industrials have trailed the S&P 500 thus far this year, suggesting concern with the sustainability of this year’s rally: