One of the things I periodically check is the twelve-month relative performance for the various S&P 500 sectors relative to the broad index. This type of analysis can give clues to out-of-favor investments that may be due for a bounce or in-favor investments that may be a bit stretched on the upside. In essence, it helps provide good contrarian plays for overweighting or underweighting sectors. I smooth the data and then look for buy or sell crossing points in the moving averages for when to shift in or out of a sector. For example, I received a very timely sell signal on energy on August 15th 2008 and have waited for a buy signal ever since. FINALLY, after nearly two years we have a buy signal on the 12-month relative performance differential for energy, which came on August 8th 2010. While the buy signal was given nearly four months ago there is still likely more outperformance by the energy sector relative to the S&P 500 ahead.
As mentioned above, I like to periodically look at how the 12-month relative performance spread for the S&P 500 sectors are doing and commented upon it in an article written back in April of this year called, "Revisting The Dual-Edged Sword of Investing: Risk vs. Reward”. From my vantage point at the time, I saw two key sectors that stood out as the most attractive buying opportunities: telecommunications and energy. In regards to telecommunication, the following commentary and chart from the April article were highlighted:
Laggards—More reward than risk at this juncture
At the other end of the relative performance extreme are sectors traditionally viewed as defensive or less tied to the general economy than cyclical sectors. What absolutely takes the prize as top underdog is the S&P Telecommunication sector, which has grossly underperformed the S&P 500 by the widest margin in more than two decades. The sector sports the highest dividend yield (5.81%) of all S&P 500 sectors as well as the third lowest trailing P/E (13.58), making it a bargain among its sector peers.
Source: Bloomberg
Since that time the telecommunication sector staged a strong advance relative to the S&P 500 such that its 12-month relative performance went from very oversold (deep negative territory) to above neutral.
Source: Bloomberg
The other standout back in April was energy, whose relative performance mirrored the defensive sectors even though the sector is focused on commodities. Commentary and charts from the April article are provided below:
Energy–The Odd Ball
While the energy sector is not considered a defensive sector it has certainly traded like one. Like the laggards mentioned above, the S&P Energy sector’s relative performance is at the third lowest point in nearly two decades, despite rising energy prices. For the ardent energy bulls this perhaps represents a tremendous buying opportunity on a relative performance basis. While the sector has underperformed the market for the last year, there may be change afoot.
Source: Bloomberg
The relative strength of the S&P Energy sector to the S&P 500 shows a strong directional correlation with the Conference Board’s Lagging Economic Index and the Lagging Index put in its first positive uptick in February of this year since its prior peak in January 2009. If the Lagging Economic Index continues to improve going forward that likely spells favorable winds for the S&P Energy sector’s relative performance.
Source: Bloomberg
Arguing for a bottom actually being in for the Lagging Economic Index, and thus a bottom for energy’s relative performance, is the Conference Board’s Coincident Economic Index (CEI) that leads the Lagging Economic Index by several months. Historically the CEI leads the relative strength of the S&P Energy sector by six months and so we may see the energy sector become a market leader into the fall of this year.
Source: Bloomberg
Like the relative performance buy signal given in the telecommunications sector earlier this year, the buy signal for the energy sector’s relative performance spread in August has also been timely. Since the buy signal was given, the S&P Energy Index is up 14.4% relative to the S&P 500, which is up 6.9%. While the buy signal was given nearly four months ago, the smoothed relative performance differential (top chart below) is still well below the neutral level and well below prior extremes seen over the last decade.
Source: Bloomberg
As stated in April, the bottom in the Conference Board’s Coincident Economic Index (CEI) did foretell the bottom in the relative performance for the energy sector. The advance in 2003 in the CEI led the advance in the energy sector’s relative performance by seven months and its advance late in 2009 led the sector’s relative performance by eight months this time around.
Source: Bloomberg
In Addition To a Relative Performance Buy Signal, Technical Picture Is Bullish As Well
The weekly relative strength index (RSI) is an excellent tool to identify whether something is in a bullish or bearish trend. Readings above 50 suggest a bullish bias while readings below 50 suggests a bearish bias. As seen below, the weekly RSI for the S&P 500 Energy to S&P 500 ratio is definitively back above 50 for the first time since 2008 which suggests the energy sector is set to outperform the S&P 500 as long as this ratio remains above 50. That the sector is back to being an outperformer is confirmed with a technical breakout from the bearish trend line in place since 2008 (middle panel below). The breakout in the relative ratio of the sector to the S&P 500 was also confirmed by a breakout of the Energy Select SPDR (XLE) through the key level indicates energy has no real resistance ahead of it until it reaches the late 2007 highs to 2008 peak. Thus, the technical picture suggest the energy sector is likely to witness a period of outperformance ahead based on recent bullish developments.
Source: StockCharts.com
Short Covering: A Short Term Support for Energy?
What has been the ultimate pair trade is to short the energy sector while going long the consumer discretionary sector. This pair trade, a favorite by the hedge fund crowd, has the potential to undergo a powerful reversal as hedge funds cover their energy shorts given the recent price strength in the sector. What I noticed over summer was when the telecommunication sector began to outperform the S&P 500 there was a sharp rally with very little pullbacks which tends to occur during short covering rallies. The current rally in energy looks eerily similar to the telecommunication rally over the summer.
Source: StockCharts.com
As seen in the table below from Bespoke Investment Group, the short interest for the telecommunications service sector went from one end of the extreme to the other, with most of it occurring in the final two weeks of October. Notice that energy is at a one year high for its short interest while the financials, industrials, and telecommunications sectors are at one-year lows. This suggests there is a lot of potential short covering in energy that could propel the sector even higher. Even the most recent report from Bespoke Investment Group (11/10/10) shows the energy sector’s short interest remains at a one-year high. How much longer can the shorts hold out if energy continues to rally? Answer being...we’re about to find out.
Source: Bespoke Investment Group, Bespoke Short Interest Report (10/27/2010)
Secular Trends Update
One other thing that makes the recent outperformance by the energy sector important is that it was at an important juncture in terms of its relative weighting in the S&P 500 Index. One of the things highlighted in the April article was that energy and the basic materials sectors' combined weighting (the commodity exposure of the S&P 500) was testing a bullish trend line that needed to hold for the secular bull market in commodities to remain alive. At the same time, the secular bear market in consumer-related stocks (financials and consumer discretionary) was testing a bearish resistance line that had been in place since 2005 when the housing bubble burst. Both groups' weightings in the S&P 500 were being tested earlier in the year and both trend lines held. The commodity sectors weight in the S&P 500 rose while the consumer-focused sectors weight fell as seen below.
Source: Standard & Poor’s
If the commodity sectors' relative performance to the S&P 500 is to accelerate in the future kindled by QE2, we are likely to hear talks again about commodities being in a bubble. To answer that claim before it is even voiced I want to draw your attention to the comparison of the tech bubble in the 1990s and the current commodity weight in the S&P 500 below. What I did was overlay the bottom in the tech stocks and advance it 11 years to overlap wit the commodity sector’s low for their weight in the S&P 500.
With all the bubble talk about commodities back in 2008, they didn’t even breach more than 21% of the S&P 500 while the tech bubble peaked with a weighting near 35% at the peak. Looking below, the secular trend of investors shifting capital towards commodities stocks remains alive and well as their combined weighting shows a series of higher highs and higher slows since 2000. The tech bubble burst with the sector reaching a high of 35% in 2000, the consumer bubble burst with financials and consumer discretionary’s combined weight of 33% in 2007. Currently the commodity-focused sectors' combined weighting of 15.3% at the end of November is a far cry from bubble territory. Remember this little fact the next time you hear about commodities becoming another bubble.
Source: Standard & Poor’s
It’s not hard to understand why commodities rallied back so strongly and why the secular bull market in commodities remains alive and well. There are two components to the secular bull market in commodities, one is the interplay between supply and demand and the other has to do not with how much commodities are rising in value, but rather how much dollars are decreasing in value. With another round of quantitative easing now underway (QE2) and the possibility for the European Central Bank to follow in the footsteps of the U.S. and Japan (who by the way is now buying their stock market, let alone government bonds!), it’s no wonder why commodities are rallying relative to continually devaluing fiat currencies.
The other component is burgeoning demand in the developing world that is putting a strain on existing supplies. World oil demand is literally a stone’s throw away from its 2008 peak while non-OECD oil demand barely skipped a beat during the global recession of 2008 and has already increased more than 6% from its 2008 highs.
Source: Bloomberg
While many of the world’s stock markets were peaking in 2007 and imploded in 2008, what garnered far less attention was that for the first time in history the non-OECD countries consumed more of the world’s total energy demand than had the OECD countries. As developing nations continue to consume more and more energy, and commodities in general at a faster rate than the developed nations, the secular bull market in commodities is likely to continue.
Source: Bloomberg
In Summary
We now have a technical buy signal that suggests there is going to be sector rotation into energy based on the 12-month relative performance differential and rapid short covering by the hedge fund community. Both the energy and basic material sectors are likely to increase in the S&P 500 as the secular bull market in commodities continues. We advise ignoring all talk about commodities being in a bubble, that is until their combined weight approaches 30% of the S&P 500 market capitalization. This is likely to be years away as the combined sector weight would have to double and the fundamentals remain strong given fiat currencies are being debased across the globe and developing countries' commodity demand continues to soar. It’s been a long wait for the energy bulls to get their share of the spot light—two years to be exact—but that appears to be changing as we finally have a buy signal in the energy sector’s relative performance.
