The following excerpt is from my report “Outperforming Equity Market Benchmarks with Sector Rotation.”
… By having good software in place and reviewing market activity on a regular basis, we can identify important developments in sector rotation as they unfold, which can make a significant contribution to investment performance.
In order to do this, we need to scan the market on a regular basis, to identify which stocks are forming the main bullish and bearish technical signals that often tend to work in a leading manner.
Based on detailed study of the “Chart School” program from Investor’s Business Daily and other sources, I have created an outline covering all the most important technical conditions for buying and selling stocks.
Bullish technical developments which form “Buy” signals include:
• A breakout to a new high, after forming a base or consolidation period.
• An upturn from a support level. One common situation is a pullback to the 50-day moving average, followed by signs of renewed buying, such as a strong move up on big volume.
Other situations are bearish, and indicate that stocks should be sold. These can be divided into two types: offensive and defensive.
Offensive selling refers to selling into strength when a stock is very overbought. Offensive sell signals include:
• A stock rising above its upper trend channel
• A “climax top” (an example is shown in the full report).
Defensive selling is done when a stock starts to turn down. Defensive sell signals include:
- A sharp drop below the 50-day moving average.
- A downturn from a resistance level.
- Money flow turns negative.
Case Study: Sector Rotation in 2014
Every year there are likely to be several major shifts in group rotation within the market. As a case study, we will review some key market events in the year 2014.
… In summary, some of the correct moves in sector rotation in 2014 would have been as follows:
… August – October:
- Move to an underweight in the energy and basic materials sectors.
- Move to overweight in groups that benefit from lower oil prices, such as airlines and retailers.
In each case there were specific “buy” and “sell” signals present in the charts. Recognizing these signals would be extremely valuable for making good investment decisions.
Sell signals in the energy stocks
As the price of oil peaked in the summer of 2014, the oil stocks also started to turn down, giving a number of sell signals in the July – September period.
A good example is provided by Canadian Natural Resources (CNQ). This stock had a pattern similar to USO, forming numerous sell signals from July to September 2014 (see Figure 12 below):
Figure 12 Canadian Natural Resources (CNQ) Daily – 2014
• On 8/1/14 it plunged below its 50-day moving average on huge volume.
• However, when it rallied back to the moving average, the rally was on low volume, and instead of breaking up through this resistance level, the stock sold off sharply on big volume on 9/2/14.
• In September the stock continued to drop, and in early October it plunged below its 200-day moving average on big volume.
• Money flow and relative strength turned down in August, and continued to deteriorate in September.
This is not the behavior of a healthy stock that we want to own. The relationship of price and volume was very bearish, with sharp selloffs on big volume and rally attempts on light volume. When the stock pulled back to support levels, such as moving averages and prior lows, it did not find support there, but instead broke through those levels on huge volume. These are all signs of institutional selling.
Notably, the vast majority of energy stocks, as well as energy ETF’s, all behaved in a similar manner during this time period.
Thus, during the July 2014 – early October 2014 period, both the price of oil and most of the oil stocks were showing numerous sell signals, warning that the energy sector was becoming increasingly risky and that the trend was down. In addition the outlook for oil prices was bearish for various fundamental reasons.
As these developments unfolded, it was clear that a move to an underweighted position in the energy sector was warranted.
Following these developments, oil prices plunged from the $90 range to below $30 a barrel by early 2016, and the energy sector underperformed the S&P 500 for more than a year.
Figure 11 USO (oil prices) Weekly — late 2012 thru early 2015
… Recognizing the type of developments shown above, and using them to make decisions on stock selection and sector weights, would make a substantial contribution to one’s investment performance relative to the S&P 500 in 2014.
The preceding discussion provided a good example of detecting major institutional selling in a group of stocks, and moving to an underweight in the group.
By comparison, the next case study shows a bullish situation, in which a group of stocks showed major institutional buying activity, leading to the conclusion that we should overweight the group.
(The following excerpt is from my report “A Consistent Process for Equity Market Strategy.”)
Case Study: The Semiconductor Stocks in 2016
In mid-2016, the S&P 500 had just bounced back strongly after a sharp selloff related to Brexit, and the technology sector was a leading sector.
Within that sector, the semiconductor stocks were a leading group, as evidenced by the fact that the relative strength line of the semiconductor group broke out to a new high in July 2016.
We would not make an investment decision based only on the relative strength line. But by noting its breakout, we can focus on this group and research the underlying stocks in more detail.
We can study the fundamental outlook, as well as charts of the individual stocks. In so doing, we can put together the pieces of the puzzle, and see if the bullish picture from the relative strength line is confirmed by additional evidence.
In July 2016 many of the largest stocks in the semiconductor group had bullish chart patterns, such as Lam Research (LRCX), which had just broken out to a new high (see Figure 9).
Figure 9 Lam Research (LRCX) – example of a semiconductor stock in July 2016
Over the next few weeks, the group continued to gain strength, as more of the semiconductor stocks moved higher in response to good earnings news. The breakout in LRCX was the start of a major move higher (Figure 10).
Figure 10 LRCX – behavior after the breakout shown in previous chart
Why did the breakout in LRCX in July 2016 lead to such large gains? After all, in some cases breakouts fail.
One of the main reasons is that the whole industry group was starting to gain strength, as evidenced by the bullish charts of numerous other semiconductor stocks. In mid- to late-2016, many of these stocks were forming bullish patterns, including:
- Breakouts to new highs
- Increases in money flow
- Signs of renewed buying after pullbacks to support.
These signals did not all occur on the same day or in the same week, but there was a trend unfolding over a number of weeks.
By spotting the signs in stock behavior that often occur at the start of big moves, and aggregating this data by sector and industry group, we can see which groups are starting to gain strength.
This is very different from looking at rankings that simply show which groups have already gone up the most.
Looking at the fundamentals, most of the semiconductor stocks reported significant positive earnings surprises in July 2016.
In general, both fundamental and technical data for the semiconductor stocks was very positive in July 2016, leading to the conclusion that the group should be overweighted.
We want to own the “strongest stocks in the strongest groups” but we need to find them in the early stages of their moves, not just after they have already gone up. This case study shows an example of finding such stocks in a forward-looking manner.
A Process to Monitor Sectors with both Fundamental and Technical Data
As seen in the 2014 case study, the market sectors generally hand off leadership from one to another, like runners in a relay race. After a big move up, one group gets tired and succumbs to profit-taking, while another group starts to rise and takes over the lead role.
Thus, as we make decisions in managing investment portfolios, we should continually ask:
- What groups are starting to act well, with stocks forming various bullish signals, such as breaking out of bases, or showing upturns in relative strength?
- What groups are showing signs of peaking, with stocks forming various sell signals?
In order to answer these questions, we need to have procedures in place to consistently monitor the market, so that we can identify which stocks and groups are forming bullish or bearish signals.
In order to address these issues, I have designed and built a weekly process for managing market data. This includes pattern recognition software to scan the market and find all stocks forming various technical patterns. For example, each week we can identify which stocks have just broken out to new highs, etc.
Then this technical data is aligned with fundamental data from a quantitative stock selection model, showing, for example, which stocks have bullish fundamentals based on factors such as earnings estimate revisions. As an example, the figure below shows a summary of technical and fundamental data for the various market sectors as of 10/5/18.
The spreadsheet from which this summary is taken contains much more detail. In addition to this sector data, it provides more detailed data on over 100 industry groups, as well as company-specific data on over 1,000 individual stocks.
… This process provides the ability to cut through the information overload, gain insights into sectors and industry groups, and zero in on which stocks are good candidates for both buying and selling.
Coordinating Sector Analysis with Market Conditions
Finally, it is important to note that sector rotation should be viewed within the context of overall market conditions. Analysis of sectors and stocks should be coordinated with the behavior of the overall market.
… This is best done with a top-down, step by step process. First we determine the condition of the overall market, then we analyze sectors, industries, and individual stocks. Then we can put together the pieces of the puzzle and draw investment conclusions.
Note: an example of this complete investment process is shown in the nearby report entitled “Investment Strategy Case Study.”
To gain the benefits of this investment research process, please contact Jonathan Strauss, CFA: jon@straussresearch.com