Sector Rotation – Remains Bearish

SECTOR ROTATION MODEL

A useful way to determine the state of the stock market and the economy is to compare how various market sectors are performing. Research and history have shown that certain market sectors do better at market tops, while others do better at market bottoms.

The chart below shows the Stockcharts Sector Rotation Model through up and down cycles and it plots the relationship between stocks and the economy. The red line tracks the stock market and the blue line tracks the economic cycle.

Source: StockCharts.com, Sector Rotation Model by John Murphy

We have seen that the (1) stock market usually changes direction before the broader economy. Going back to the chart, the boxes on top of the chart show how the various sectors perform at turning points for both.

STOCKS LEAD ECONOMY LOWER

The stock market peaked at the start of the year. Thereafter, the S&P 500 fell into a bear market territory with losses exceeding -20%. Historically, (2) peaks in stocks usually lead peaks in the economy by six to nine months, which suggests that the economy is in recession or heading into one.

That’s where sector rotations come into play.

ENERGY LEADERSHIP MAY BE A BAD SIGN

The sector boxes at the top of the chart show materials and energy leading the market as it forms a major peak. Their outperformance is based on strong commodity and energy prices which signal inflationary pressure. This is the same pressure which prompted the Fed to start raising interest rates.

(3) The sign that stocks have peaked is money flowing into defensive market sectors like consumer staples, health care, and utilities.

TECHNOLOGY AND CYCLICALS LEAD AT MARKET BOTTOMS

Looking to the boxes on the left of the chart, Technology and Consumer Discretionary stocks start to show market leadership at stock market bottoms. Thereafter, investors will see that Communication Services and Industrials will begin following them higher. (4) It also shows stocks bottoming before the economy.

SECTOR ROTATION FITS BEARISH OUTLOOK

The Table below shows the relative performance of the eleven market sectors since the start of the year. Energy remains the strongest sector with Utilities, Consumer Staples, and Health Care following.

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That sector rotation fits exactly with the model shown in Sector Rotation Model for a market top.

Additionally, the weakest sectors for the year are Communication Services, Consumer Discretionary, and Technology.

The fact that those three remain the year’s weakest sectors (combined with continuing leadership in energy and defensive sectors) carries a negative message for the stock market and the economy.

Source: StockCharts.com, Performance YTD 2022

WEEKLY SECTOR RANKING REMAINS BEARISH

The table below ranks stock sector performance for the last week, ended Friday November 04, 2022.

Source: StockCharts.com, Performance (Weekly) ended November 04, 2022

Energy remains the market’s strongest sector which suggests that the inflationary impact of higher energy prices remains a problem for stocks and the economy. Will this encourage a more hawkish Federal Reserve?

Materials have moved into second place also hint at higher commodity prices which is potentially inflationary. Aluminum, copper, and chemicals led that sector higher.

Technology, Communication Services, and Consumer Discretionary stocks remain the market’s weakest sectors. Remember that the Sector Rotation Model shows those three sectors leading stocks higher at market bottoms. And there’s no sign of that happening.

(5) Energy leadership and technology weakness is usually a bearish sign. So is weakness in economically-sensitive consumer cyclicals. All of this suggests that stocks remain in a bear market.

The fact that stocks show no signs of a major bottom also argues for a weaker economy and a likely recession.

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