While the major index returns are up double digits this year, it hasn’t been a buy and hold year. Like many years before this one, rotation has been a key element in producing those returns. For instance, if you’ve been invested in many consumer staples like Coke, Altria, and Wal-Mart, you actually lost money this summer while the market rose. If you’re going to be a buy and hold investor, it’s important to diversify so that if you can’t move out of the wrong areas, at least you have some of the right areas working for your portfolio to balance out the negative returns. But if you’re a speculator or trend-follower, it’s important to rotate into the right sector at the right time. As I said last week, rotation is to the stock market what location is to real estate. With the outperformance of cyclical stocks over non-cyclicals this summer, analysts are posing the question, “Is it time to rotate into staples?”
Overweighting staples, healthcare, and utilities was the right move to make in February, but that changed mid-April. On May 9th, I wrote about the move into cyclical stocks and the return of the beta trade (see post). This has played out over the past five months, and it may continue a while longer. So far, there hasn’t been a break in this trend.
I’ve seen some recent analytical work from a fundamental and technical basis that argues for an increased weighting in consumer staples again. The primary reason is that consumer staples are near oversold levels and cyclicals have had a good run. The fundamental reason is that energy prices have risen and they’re likely to affect discretionary spending and growth in the economy.
The Citigroup Economic Surprise Index has been rising in 2013 as economic results have, on average, beaten economic consensus. The ISM services miss today was a shot across the bow on cyclical stocks. A contrarian economist might suggest that it’s time for economic results to disappoint; and therefore, time for cyclicals to take a break and staples to take over.
I believe this call may be early. Most of the indicators I use to follow rotation haven’t signaled a turn yet. So let’s review them:
Consumer Discretionary vs. Staples
One of the best indicators to follow is a relative strength chart on both the S&P Consumer Discretionary SPDR (XLY) and the S&P Consumer Staples SPDR (XLP). This essentially pits the performance of one over the other in the form of a ratio that can be charted. The chart below shows the trend of outperformance in the Consumer Discretionary sector over Staples for the past five months. Note that this trend is intact and note that while the S&P has been down 9 out of the last 11 days, this indicator continues to show that staples are underperforming.
Cyclicals vs. Consumer
Another similar indicator is by doing the same relative strength ratio of the Morgan Stanley Cyclical Index (CYC) versus the Morgan Stanley Consumer Index (CMR). The Morgan Stanley Cyclical Index is heavily made up of large multi-national industrial companies like Caterpillar, 3M, Dow Chemical, and Dupont as well as basic material companies like Alcoa and U.S. Steel. A rising chart here indicates a steer towards investments that are economically sensitive. Over the last few years, investors have called this a “risk on” style of investing and it’s still on. Note here too, that while the market has pulled in over the last 11 days, this indicator has moved higher – which is pro cyclical.
Stable Staples
The Consumer Staples ETF (XLP) has been consolidating since May and shows no sign of breaking out. The chart below shows many technical aspects here:
- While the S&P 500 may be considered consolidating within a rising wedge (ABCDE), it’s forming higher highs and higher lows
- The staples sector continues to consolidate within a trading range
- Staples may become oversold fairly soon
- The most important factor, however, is that it continues to underperform the S&P 500 with no sign of change yet.
Rotating out of cyclicals and rotating into staples is a defensive call and it has worked at times. Typically, this has happened during market corrections, which have so far been short short short. This February was the first time I’ve seen it while the market rose to new highs, but that has been the exception and not the norm. Consumer discretionary stocks outperforming consumer staples is a key characteristic in a bull market. Note the breakout in relative performance after a three-year consolidation.
The most interesting factor to me is that retail and transports—highly sensitive to oil prices—have been performing well despite the climb in energy prices. Note my two indicators below that show a minor correction this summer when West Texas Intermediate Crude broke out above 0, but both have turned back up in September while WTIC has fallen to retest that level once again.
If oil heads down below 0 it will be a boon for the economy, which is still based on the consumer. Oil has and always will be—until an alternative is found—a tax on the consumer’s discretionary spending. The increased production out of the mid-U.S. points towards lower prices as long as inflation and China’s economic growth continue to be in check.
Finally, the last indicator that suggests the market continues to seek beta plays is the outperformance of small and mid-cap stocks over large-cap stocks. Typically, larger companies are more mature and made up of cash cows spitting out dividends and stock buybacks. Smaller companies use their investments to reinvest in the company because their rate of return on investment in growth projects is much higher internally than it is in the market. The Russell 2000 was at an all-time high just three days ago.
Conclusion
A rotation now into consumer staples is really a bearish call on the market or a contrarian view that they’re a value here now. The problem with that philosophy is that things of value can stay a value as they trend down or go nowhere. Better performance has been found in cyclicals and consumer discretionary stocks. There has been no change in this trend, even with the selloff in the market over the past 11 days and the 5-month consolidation in the broad stock market indexes. A rotation into staples is early. In my 19 years in the business, a common excuse to being wrong is being early. I’d rather be right about the trend then early and wrong, because wrong can last a while.
The past three years have been plagued by many bearish catalysts and not one has sent the financial markets into a bear market, thanks to the Fed and corrections in energy prices. Consumer discretionary stocks broke out of a 3-year consolidation in performance and have only just broken out five months ago. I think they still have room. If the trend reverses, I’ll change my mind.
