SECTOR ROTATION MODEL REMAINS BEARISH
SECTOR ROTATION MODEL .. One of the more useful ways to help determine the state of the stock market and the economy is to compare how various market sectors are performing. Certain market sectors do better at market tops, while others do better at market bottoms. Chart 1 shows the Stockcharts Sector Rotation Model through up and down market cycles. It also plots the relationship between stocks and the economy. The red line tracks the stock market, while the blue line tracks the economic cycle. The first lesson is that the stock market usually changes direction before the economy. While the boxes on top of the chart show how the various sectors perform at turning points for both.
STOCKS LEAD ECONOMY LOWER...The stock market peaked at the start of the year with the S&P 500 falling into a bear market with losses exceeding -20%. Historically, peaks in stocks usually lead peaks in the economy by six to nine months. That suggests that the economy is in recession or heading into one. That's where sector rotations come into play.
ENERGY LEADERSHIP IS A BAD SIGN...The sector boxes along the top of Chart 1 show materials and energy leading the market as it forms a major peak. Their strength is based on strong commodity and energy prices which signal inflationary pressure (which prompts the Fed to start raising interest rates). The sign that stocks have peaked is money flowing into defensive market sectors like consumer staples, health care, and utilities.
TECHNOLOGY AND CYCLICALS LEAD AT MARKET BOTTOMS... Looking to the boxes on the left of the chart, Technology, and Consumer Discretionary stocks start to show market leadership at stock market bottoms with Communication Services and Industrials following them higher. It also shows stocks bottoming before the economy. Let's compare the sector rotation model in Chart 1 to this year's sector performance.
SECTOR ROTATION FITS BEARISH OUTLOOK... The table in Chart 2 shows the relative performance of the eleven market sectors since the start of the year. Energy remains the strongest sector with Utilities, Consumer Staples, and Health Care following right behind. That sector rotation fits exactly with the Model shown in Chart 1 for a market top. In addition, the weakest sectors for the year are Communication Services, Consumer Discretionary, and Technology. The fact that those three remain the year's weakest sectors (combined with continuing leadership in energy and defensive sectors) carries a negative message for the stock market and the economy. Let's take a more short-term view of recent sector performance to see if any major changes have occurred.
WEEKLY SECTOR RANKING REMAINS BEARISH... The table in Chart 3 ranks stock sector performance for the last week. And it's not very encouraging. Energy remains the market's strongest sector which suggests that the inflationary impact of higher energy prices remains a problem for stocks and the economy (and encourages a more hawkish Fed). The fact that Materials have moved into second place also hint at higher commodity prices which is potentially inflationary. Aluminum, copper, and commodity chemicals led that sector higher this week. Even more concerning is the fact that Technology, Communication Services, and Consumer Discretionary stocks remain the market's weakest sectors. The Sector Rotation Model in Chart 1 shows those three sectors leading stocks higher at market bottoms. There's no sign of that happening. Energy leadership and technology weakness is usually a bearish sign for stocks. So is relative weakness in economically-sensitive consumer cyclicals. All of which suggests that stocks remain in an ongoing bear market. The fact that stocks show no signs of a major bottom also argues for a weaker economy and a likely recession.
