A Tale of Two Sectors

The Business Cycle and Sector Rotation

The business cycle undergoes a set series of chronological events which are also related to primary trend peaks in bonds stocks and commodities, as laid out in Figure 1. You can read about this concept in greater detail here. Based on the position of these three markets relative to their 12-month moving averages, we are currently somewhere in the area being flagged by the vertical pink shading. That's because the commodity market is the only one above its MA.

I am drawing this to your attention because the position of the cycle often has a significant influence on the relative performance of the various sectors and industry groups. At the beginning of the cycle, by the arrow labelled S for the stock market bottom, the Fed has already begun to inject liquidity into the system, which has the effect of softening interest rates. That fact, combined with weak economic activity acting as a moderating force on inflation, encourages consumers to raise their spending. It's also the signal for equity investors to purchase consumer cyclicals, which normally outperform in a relative sense at this stage of the cycle.

Further along the curve, as displayed in Figure 1, economic conditions tighten and the inflationary part of the cycle gets underway. That's a bearish factor for consumer spending in the discretionary area, but a bullish one for metals, whose prices are rising because of the tightness in the system. Thus, we have the tale of two sectors consumer cyclicals, which should be underperforming at this stage of the cycle, and miscellaneous metals, which should be doing better. What, though, do the charts say?

Consumer Cyclicals Fading

Chart 1 features the long-term relative strength line of the SPDR Consumer Cyclicals (XLY) versus the S&P. It certainly supports the idea that the cycle is in a later stage. After all, the RS line is below its 12-month MA and the long-term KSTis also in a negative mode. Equally important is the fact that the RS line experienced a false upside breakout late last year. Whipsaws, such as this, are often followed by above-average moves in the opposite direction to the breakout, as traders scramble to get back on the right side of the market. That breakout has now been confirmed by the RS line dropping below its 2010-2022 up trendline. This one has much more serious consequences since the line is lengthy and has been touched or approached on several occasions.

The new downtrend now underway is likely to morph into something greater than a normal cyclical retreat; something more characteristic of the 2002-2008 period, perhaps? It's worth noting that, between 2002-2009, commodity prices rallied sharply, not unlike the present situation.

I have a series of chart lists using the same long-term template as Chart 1. The individual charts compare a specific sector to each of the others. This approach then helps to discover the strongest and weakest sectors from a long-term perspective. A review of the XLY, compared to other sectors, confirms that, almost universally, these cross-sector relationships have broken down technically.

Chart 2, for instance, compares consumer cyclicals to financials (XLY/XLF). The ratio has broken a long-term up trendline and completed an upward-sloping head-and-shoulders top. Further weakness shows up in the anemic KST rally that accompanied the late 2021 high.

Chart 3 pits the XLY against the staid SPDR Utilities (XLU). Here, we see a long-term KST sell signal supporting the recent break below the two trendlines.

Metals Emerging

For the last year, energy has by far been the best-performing sector. However, another area, which is also consistent with superior late-stage cycle performance, is metals. In that respect, Chart 4 compares the SPDR Metals and Mining ETF (XME) to the S&P Composite. In mid-2020, the RS line violated the dashed secular down trendline, which told us that downside momentum had dissipated. It's now gone one step further by completing a seven-year double bottom. That action, along with the re-accelerating KST, suggests that the trend of superior performance by the XME is likely to extend for several years to come.

Chart 5 compares the XME to the SPDR Semiconductor ETF. It seems to have reversed its 14-year down trend in relative strength, as it, too, has completed a double bottom formation.

In Chart 6, the cross relationship is with the iShares Transportation Average (IYT). In this instance, the secular down trendline has only just been penetrated. More importantly, though, the ratio has completed and broken out from a 7-year double bottom formation.

Finally, Chart 7 indicates that the XME, having penetrated its secular down trendline against the XLY, has now completed a 3-year inverse head-and-shoulders formation. The KST has also begun to re-accelerate sharply on the upside.

Conclusion

Many of these relationships are overextended on a short-term basis and could well correct near-term, but the overall message is that the last couple of years have seen a basic long-term change in the relative fortunes of cyclicals and metals, a tale of two sectors indeed.

Good luck and good charting,

Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Groupof Walnut Creek or its affiliates.