Ominous Signs Ahead from Sector Rotation Model

Jun 4, 2007: 1:30 PM CST

For those who study sector rotation as a method for understanding the broader market, there are ominous signs on the horizon for the broad market if the model is correct.

In a summary, sector rotation theorists believe the market functions in an orderly progression where certain sectors outperform at certain phases in the business cycle, and this creates the market cycle of sector strength and corresponding weakness. The stock market is said to lead the economy by three to six months.

I recommend studying the model much deeper, and there are texts which address the subject far greater than any website or blog can do.

Here is the most recent chart from StockCharts.com of sector flow:

sector-flow-june-3.jpg

What we are seeing is that energy is outperforming all others, and the progression is marching forward as expected. The chart is set-up to show the proper flow of money/sector strength from left to right (as the cycle progresses). Here is a basic explanation chart from StockCharts.com:

rotation-model.jpg

I have drawn in the hand myself, where I interpret the model is placing us in the current cycle. Notice that when energy prices outperform for an extended period of time, the market tends to peak before the economy begins to slow. The market is anticipating the effect of higher energy prices on the consumer and businesses and forecasting they will have to cut back on production to meet the slowing expenditures of the consumers (because higher energy prices serve as a ‘tax’).

Again, if this is correct, we are close to a major peak in the cycle which began around 2003 at the bottom of the bear market from 2001-2003. Cycles tend to last 3-5 years as the economy experiences expansion and contraction. It’s possible we’ll have a mild correction, similar to that of 1996 (flat market) and avoid a major downturn, but you’ll have to consult other sources to determine your views on this. The sector rotation model is only one way of interpreting the data.

Nevertheless, we see the perfect ‘stairstep’ pattern expected with the model, and this tells me that a market peak is nearing its completion, and a downturn in the market is ahead of us prior to economic weakness (which is already being forecast by many economic prognosticators).

This is part of macro-analysis and probably will not mean as much to a day trader or even a pure swing trader, but macro-investors and position traders should take note when establishing long positions at potential market peaks – the risks may outweigh the rewards in the near future.

Combine this snap analysis with the fact that the market tends to languish during the summer months before picking up steam around November and you have a tenuous market condition at best for investors.

Please be careful and don’t bet the farm on your longer-term trades. Maintain disciplined risk-control and don’t overload the boat because the market has been kind to you the last few months. Also, don’t confuse ‘brains’ with a bull-market where everything tends to rise.

6 Comments

6 Responses to “Ominous Signs Ahead from Sector Rotation Model”

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