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The
Market Cycle Model Works, Next Year's Best Sectors |
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As promised
in Monday's
edition, today we're going to look at another aspect of the economic/market
cycle... sector leadership. There are plenty of theories as to which
sectors should lead certain stages of the cycle; we're going to compare
the theories to reality, and glean a forecast from the information.
Considering
they're all working with the same data, one would think different research
groups would come to the same basic conclusions about which sectors should
lead or lag at a certain phase of the economic cycle. There was some assuring
overlap, but a handful of discrepancies.
 Regardless,
the aggregate data still has value even if only for academic reasons.
The nearby table
shows the most common sequence of sector strength in particular economic
and market phases. It's meant to be viewed sequentially from the 'top down'.
A quick explanation
of two items is in order before you do that, however.
First,
you'll see some stages of a market recovery don't have a corresponding
stage of an economic recovery, and vice versa. Though there are several
sequential models like this available on the web, none of them really offered
detail of this level. Where we had to (for the sake of accuracy), we chose
not to overlap data that we shouldn't overlap just because it would have
looked nice if we had. Besides, it's the sequence that matters... not the
labels themselves.
Second, you'll
also quickly see the market's strong periods don't necessarily synchronize
with the economy's strong periods, and vice versa. That's not a mistake.
The market tends to lead the economy - almost predictive of it -
six to nine months in advance. In other words, if you're waiting to invest
in stocks until the recovery becomes crystal clear, then you've already
missed the boat.
In the bigger
picture, investors should know the model is simply an average tendency,
pieced together by Standard & Poors, John Murphy, and others. It would
be unreasonable to expect a model such as this one to precisely pan out
each and every cycle. If it's accurate two out of three times, that's still
pretty impressive as well as useful.
In other words,
it's not a trading gospel - it's just a framework.
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Applying
Theory to Reality |
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OK, now that
we know what 'should be' happening, let's put the theory to the test.
 We
can all probably at least agree that the economy bottomed sometime between
Q2 and Q3, and is on a recovery path.... even if a long one. And, the argument
that a new bull market started after March's bottom holds water as well.
With that being the case, we're probably somewhere between early and middle
bull (in terms of the market), and between trough and early recovery (in
terms of the economy). As such, financials, then technology, then transportation,
then discretionary stocks should have led the way... and perhaps still
be leading.
How'd the
market do? Take a look at the nearby chart which shows the relative
performance of those four groups since March, compared to the S&P 500
(which is marked by the black dots). Though it sure wasn't by much, nor
was it pretty, those groups were mostly the market's leaders; the
discretionary/cyclical group was merely average.
We'd be the
first to acknowledge the strength form the financials was prompted more
by their complete decimation prior to the March low than it was by their
impending fundamental improvement, but the model still correctly
made the call. Moreover, had the financials not done so miraculously well,
the other two leading sectors would have appeared much stronger on a visual
basis.
Bottom line?
Not
that we were testing it for validity before we considered it, but the rotation
model does indeed appear to have some merit. It's still not a tool
to use blindly, but it's not a waste of time and space either.
So
what's next for stocks? First and foremost we suspect the financial
sector will cool off. That's not to say all financial stocks will do poorly,
but it's no longer a case where the rising tide is lifting all boats. That's
in line with the sequential model above, which suggests the group is one
you want to own during and after a trough, but should be replaced by other
groups once we get this far past a bottom.
 As
for transportation and technology, both still seem to be in their prime
(as they should be), and as such both are still worthy holdings. That may
last through the 'middle bull' phase.
As for discretionary
stocks, frankly, it was a little unfair to start their clock back at the
March bottom simply because they aren't expected to start shining until
we're in the mid bull/early recovery phase we likely just started. If you
have faith in the model, you should also have enough faith to keep holding
those cyclical names.
As for which
sectors are in the queue, industrials and materials should be the next
hot spots. Don't jump the gun though. The current phase - whatever it
is - could last for months. You may wish to phase into those sectors
between now and then, but there's not any reason to dive in immediately.
We'll be revisiting
this cycle-sequence chart from time to time, when it's merited.
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Updated: 8:15 pm PDT (03:15 GMT), November 2, 2010
