Rotation: The Lifeblood of the Market

Ralph Acompora, the “Godfather” of Technical Analysis, has made many interesting comments about the market throughout his career. The title of this post is one of his and it is top of mind for many investors right now. Rotation plays out under the surface of the market. While many people are caught up in the headline index price, the real opportunity lies one to two steps deeper. Rotation can take place across factors: growth to value, high beta to low volatility and large cap to small cap to name a few. It can also play out across sectors. For the majority of the past two years, the decisions have been fairly simple. Large cap growth has been the place to be. However, over the past two to four weeks there has been a shift taking place. Small caps are beginning to move higher and outperform large caps. Value stocks and the cyclical sectors of the market are showing signs of life as well. The question is how do you know if rotation in the near-term is simply mean reversion or the start of something bigger? 

Should you rotate or wait?

To get a sense of what rotation looks like in the market currently, we can use a relative rotation graph (RRG) of the SPDR Sector ETFs. The four quadrants represent Leading, Weakening, Lagging and Improving sectors moving clockwise around the S&P 500 which is sitting at the intersection of the x and y axis. In this example I am using a 4 week moving average to determine the trend of the individual sectors. It’s fairly clear that the cyclical sectors are moving in the right direction with Materials and Energy in the improving quadrant. Industrials and Financial are still lagging but they are making a turn higher. At the same time, the key leaders over the past year (Technology and Health Care) are moving toward a weakening position. 

Here is the rub. Something similar played out in the fourth quarter last year as cyclical sectors began to improve, and even lead in the case of Financials, as the US and China came to an agreement on Phase One of a trade deal (remember those simpler times when US / China trade relations were the biggest concern; that seems quaint now). However as 2020 began, this dynamic quickly reversed and the growth sectors began to lead once again. Investors who jumped on the cyclical bandwagon were quickly blindsided as the COVID-19 outbreak led to a shuttering of the global economy. Growth ground to a halt and in a slowing or no growth world, growth is the asset to own. 

How do you avoid this headfake? Is there a way to know that a near-term rotation is going to turn into a lasting trend. Unfortunately, the answer, as with much in the market, is no one knows for sure. Clearly we know that we should be looking at more than one month of data. Personally, I look at a blend of 3, 6 and 12-month performance in the rotation strategies that I run for myself.

Looking at it this way, the column on the right is in focus and a momentum strategy could be built using the sectors that are higher over the blended period. At this point, there is only one  “cyclical” sector of the market that I would even consider, Materials. Here is what Pete Carmasino had to say about this sector in a recent post. Perhaps the others will be positive soon and can be considered for addition to the portfolio. Until that time, I am content to own what’s working. 

Taking the analysis a step further, if we look at the current ETF Power Gauge Ratings for the sector ETFs, we can see that all of the cyclical sectors have bearish ratings except for one…Materials! For the other three cyclical sectors (Industrials, Financials and Energy) the market and model are in agreement; Bearish rating to go along with Bearish momentum. 

We can now combine the two ideas, momentum and the ETF rating to begin to build a portfolio that takes advantage of rotation in a disciplined way and not in a way that chases what’s hot in the moment. This would lead to Health Care, Technology, Communication Services, Consumer Discretionary.

Let’s assume that we don’t want to ignore the Bullish momentum in Materials and Staples.  For the Materials, XLB is ranked number five in its group. There are two funds that rank higher and have better ratings. One is the Sprott Gold Miners ETF (SGDM) and the other is the iShares US Basic Materials ETF (IYM). Obviously we would have to consider expense ratios and liquidity if we are going to consider one of these other funds but they were quickly found through a screen in PortfolioWise.

We can run through the same exercise for Consumer Staples and see that there are three Bullish funds that rank higher than XLP. 

Rather than blindly chasing the recent winners, combining momentum with a disciplined quantitative rating allows us to narrow our focus to the strongest of the new contenders.

Dan Russo is the Chief Market Strategist at Chaikin Analytics where he writes the Daily Market Insights newsletter and provides thematic trading and investment ideas for clients. Dan is a Chartered Market Technician (CMT) and a member of the CMT Association. He holds an MBA in finance with an international designation from Fordham University.

Follow Dan on Twitter @DanRusso_CMT

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