SECTOR ROTATIONS INDICATE A COMPRESSED CYCLE -- WHY SECTOR ROTATIONS HAVE TURNED POSITIVE -- MARKET INDEXES NOW JUSTIFY NEW LONGS
SECTOR ROTATION MODEL... The diagram in chart 1 shows the sector rotations that normally occur at different stages of a market (red line) and business cycle (green line). When we talk about a business cycle, we're normally talking about the traditional four-year cycle. That means that these shifts in market leadership often last for several months if not longer. Like market trends, however, not all market cycles are major in nature. Some are more intermediate-term and some are shorter-term cycles. What we've seen since the start of the year may be the shorter-term variety. Although the shifts in market leadership have followed the diagram pretty closely, they've happened in a relatively short period of time. Earlier in the week, I explained which market groups assume market leadership in the late contraction part of a cycle and the early expansion phase. I was describing the order of the rotations, and not necessarily their time duration. Like many of you, I've been surprised by how fast the current down cycle appears to have run its course. Energy leadership is usually associated with a market top. In January of this year, I wrote that money was starting to rotate into defensive sectors like consumer staples and utilities. Further on in a downturn, money normally starts to flow into financials as economic weakness starts to pull interest rates lower. That process may have already started. In the early stages of a market upturn, the two fastest rising groups are consumer cyclicals (like retailers) and technology. That's usually associated with a weaker energy sector. That process appears to have started as well. That's why I've described the sector rotations as having turned positive.
Chart 1
LATEST PERFORMANCE CHART... The performance bars in Chart 2 show the shifts in market leadership that have taken place over the last month (April 16 to May 18). These shifts are exactly the opposite of what we've seen through the first four months of 2005 and are much more positive for the market. All of the groups are plotted above and below the S&P 500 which is the zero line. The bars over the zero line show relative strength (market leadership). Those below the zero line show relative weakness. The three bars to the right show that the weakest market groups are all commodity-related -- gold, oil services, and basic materials. That's a direct result of a stronger dollar and weaker commodity prices. The strongest groups to the left are semiconductors, retailers, and financials. I included the Nasdaq bar to show that it was doing better than the S&P for the first time this year. That's usually a good sign for the market. The Sector Rotation Model in Chart 1 shows that the three groups that do best as the market is turning higher are financials, consumer cyclicals (retailers), and technology. In other words, sector rotations are following the sequence that normally takes place in a bottoming market. That's no guarantee that these sector rotations will stay positive, nor does it tell us how long they'll stay positive. The current sector alignment, however, appears to support the recent upturn that's taken place in the major market averages.
Chart 2
NASDAQ LEADS MARKET HIGHER ... In my view, the most significant improvement has taken place in the technology-dominated Nasdaq market. The Nasdaq Composite Index broke through its 200-day average on Tuesday and has broken its 2005 down trendline. Its relative strength line has turned up relative to the S&P 500. That's usually a positive sign for both. Nasdaq leadership is essential in any market upturn. That's what we're getting right now. One of the missing ingredients in recent market bounces has been higher volume. Yesterday's market upturn, however, saw all the major averages exceed their normal daily volume. That's a sign that institutions are starting to buy back into the market with more enthusiasm. The Nasdaq now appears headed toward its February/March peaks near 2100.
Chart 3
S&P 500 CLEARS 50-DAY AVERAGE ON RISING VOLUME... The next chart shows the S&P 500 closing above its 50-day average yesterday for the first time in two months. And it did so on heavy volume. That's a healthy combination. The S&P is now challenging its early March high near 1191. If it clears that (and I think it will), it could move closer to its 2005 high. Daily MACD lines are also rising, which is positive sign for the short-term trend. The S&P wasn't the only major index to clear its 50-day average. Virtually all of the others did it as well -- including the Dow Industrials and the Russell 2000 Small-Cap Index.
Chart 4
NYSE BOUNCES OFF 200-DAY AVERAGE ... Early last week I described the NYSE Composite Index as being the only one that didn't fall below its 200-day moving average during April. Late last week, however, a sharp drop in the NYSE pushed it into a crucial test of that long-term support line. As its chart shows, however, the NYSE survived that test and more. In today's trading, it moved back over its 50-day line. That has turned the chart from potentially negative (if the 200-day line had been broken), into a much more positive looking one. Chart 6 shows another market index that has taken a dramatic turn for the better. The Dow Jones Composite Index (which includes all 65 Dow stocks) closed under the 200-day line on Friday. Since then, however, it's bounced impressively and is now trading at the highest level in a month. I've found that one of the best times to commit money to a market is when it's bounced off its 200-day line and climbed over its 50-day line. That pretty much describes the present situation.
Chart 5
Chart 6
RECAP OF RECENT ADVICE ... I'm aware that some of our readers are somewhat surprised by what appears to be a relatively quick shift in the market and in my view of it. My shift to a more positive view started a couple of weeks ago. I had been negative on the market since the start of the year. I had expected an eventual drop back to last summer's lows. On May 4, however, when the market indexes started to rebound off their 200-day averages, I suggested reducing bearish positions and a shift back to a more neutral posture. That day's headline read: "Lighten up on Bear Positions" (May 04, 2005). I didn't, however, recommend new long positions in the market indexes. On Monday of this week, I described why an upturn in the Nasdaq was a positive sign for the market and also wrote about some positive sector rotations. Yesterday's climb, however, left little doubt that the market was turning higher. That's why I suggested that new long commitments were justified. And, as is usually the case, I believe those new longs should be concentrated in those groups that are leading the market higher. I'm not completely sure what impact the recent upturn means for the longer-term picture. In times of doubt, however, it's usually best to follow the market signals. At least for now, those market signals have turned positive.
MTA SEMINAR ON FRIDAY... I'll be at the Pennsylvania Hotel in New York tomorrow (Friday) attending the Market Technicians Association annual seminar. I'll be giving a speech on Intermarket Analysis at the Technical Analysis University from 4:00 to 5:00 pm. And I'm part of mid-year market forecast panel at lunchtime. More information on the weekend events can be found under News & Events on the John Murphy page.
