SECTOR ROTATION MODEL SUGGESTS A TRANSITION POINT BETWEEN LATE EXPANSION AND EARLY CONTRACTION -- THAT FAVORS ROTATION INTO CONSUMER STAPLES, HEALTHCARE, AND UTILITIES

CONSUMER STAPLES FOLLOW ENERGY... Chart 1 is an idealized diagram of how various market sectors do at various stages in the business cyle. The diagram is based on the work of Sam Stovall who has done extensive work in this area. There are two versions of this diagram. Let's take a look at this one first. Since basic materials and energy have been the market's strongest sectors this year, let's start there. You can see why energy is referred to as a "late cycle" performer since it's tied to rising oil prices which eventually slow the economy. When the economy does start to slow, the two sectors to the right of energy that start to do better are consumer staples and utilities. [Stovall includes healthcare in the consumer staple category]. Stovall has a second diagram which I'll summarize here. He divides the business cycle into five stages. The two middle stages are "late expansion" and "early contraction". Those two stages match the middle part of the diagram in Chart 1 and may be most representative of the current situation. Stovall's second model shows the "late expansion" phase characterized by leadership in basic materials and energy. That phase is followed by "early contraction" where leadership comes from consumer staples and utililties. Basic materials and energy have been this year's two top performers (late expansion), while consumer staples and utilities have been doing much better of late (early contraction). Let's see how 2007 sector trends match the model.

Chart 1

2007 TRENDS MATCH -- EXCEPT FOR TECHNOLOGY ... Chart 2 shows how the nine market sectors have done relative to the S&P 500 (which is plotted as the zero line) over the last three months. The numbers come close to matching the diagram in Chart 1. In a late expansion/early contraction phase, the top five performers should be materials, energy, staples (healthcare), and utilities. Although the numbers don't match perfectly, that's what we've seen. The only sector that doesn't seem to fit Stovall's model is technology. His work shows technology to be a leader at market bottoms. Although there may be unusual reasons why technology is doing better at this point in time, it doesn't seem to fit into Stovall's model. Having said that, the other five sectors seem to be supporting a more defensive view of the market. It also explains why I've been writing bullish articles lately on staples, heathcare, and (more recently) utilities.

Chart 2

WATCH FOR SHIFT IN LEADERHIP ... In my view, one of the signals to watch for in the transition from "late expansion" to "early contraction" is the change in leadership from energy to consumer staples (healthcare) and utilities. Chart 3 compares energy (blue line), utilities (red line), and staples (green line) to the S&P 500 (zero line) since the start of the year. Energy has been in the lead but may be starting to slip. If it does, that may accelerate some rotating out of energy into more defensive issues. While it's true that rising oil prices can hurt the economy, it's also true that an economic slowdown could hurt demand for that same energy. One sign that process is starting would be profit-taking in the energy patch and new buying in staples, healthcare, and utilties. [Utilities are closely tied to bond prices which tend to rise in a period of economic slowing].

Chart 3