The stock market is constantly evolving, and recent trends have shown a noticeable shift away from the dominance of tech stocks.

While some may see the recent pullback in the tech sector as a sign of concern, it represents a healthy market phenomenon known as sector rotation.

This rotation signals a redistribution of investment across various sectors, creating a more balanced and diversified market environment.

Understanding these shifts offers savvy investors new opportunities to capitalize on emerging trends and mitigate risks.

In this note, we will explore how the recent sector rotation benefits investors, highlighting the rise of small-cap stocks and the strength of non-tech sectors like financials, real estate, and utilities.

Understanding Sector Rotation

Sector rotation is a critical concept in understanding market dynamics.

It refers to the process where investors shift their capital from one sector of the market to another, often in response to changing economic conditions, interest rates, or market sentiment. This movement can result in certain sectors outperforming others at different times, depending on where the market perceives the most growth potential or safety.

Historically, sector rotation has been a regular part of market cycles. For instance, during periods of economic expansion, cyclical sectors like consumer discretionary and industrials often outperform as businesses and consumers increase spending.

Conversely, during economic slowdowns, defensive sectors such as utilities and healthcare tend to hold up better as they provide essential services that remain in demand regardless of the economic climate.

The recent pullback in the tech sector, which had previously led the market, is a classic example of sector rotation. After a prolonged period of strong performance, investors are now reallocating their funds into sectors that have been lagging, such as financials, real estate, and utilities.

This shift reflects a growing recognition that other parts of the market offer compelling opportunities for growth and income, especially as valuations in the tech sector have become stretched.

Our Approach to Identifying Sector Rotation

There are many ways to identify momentum in prices. Some people simply look at the performance of a stock going back a year. Others are more focused on shorter holding periods such as a quarter.

I have been using a methodology developed over 20 years ago that evaluates where the stock is trading today versus its 3- and 12-month moving averages. It’s stood the test of time as a useful tool to examine the momentum characteristics of equity markets and as a way to identify broad sector rotation.

The methodology assigns each stock to one of six technical stages. Conceptually all stocks move through the six stages in a clockwise manner.

Source: Global Focus Capital LLC

The journey of a stock is marked by several distinct stages, each representing a phase in its cyclical movement.

Up Trend: Characterized by a consistent upward movement in stock prices, this phase is often driven by positive market sentiment, strong financial performance, or favorable economic conditions. This is the preferred habitat of aggressive growth investors.

Deterioration: This stage signifies a slowdown in the upward momentum, where prices begin to plateau, hinting at a potential reversal in trend. Maybe investors are losing interest in the stock, or there has been a hiccup in fundamental performance. Buy the dip investors live in this stage.

Break Down: A critical phase where the stock breaks below key support levels, confirming a shift from a bullish to a bearish trend. Investors tend to panic at this stage and sell aggressively hoping to lock in any remaining gains.

Down Trend: Marked by a consistent downward movement, this phase reflects negative sentiment, often triggered by adverse news or disappointing financial results. This is the land of deep-value investors. Two things can happen here. Either the stock recovers as sentiment and business fundamentals improve, or the stock heads toward oblivion and possible bankruptcy.

Improvement: Here, stocks begin to show signs of recovery, with prices stabilizing and potentially reversing the downward trend. Maybe sentiment in the sector improves or the company in question makes the necessary adjustments to improve their fundamental performance.

Break Out: A pivotal moment when a stock breaks above resistance levels, signaling the start of a new upward trend. The consensus among investors is that fundamentals have improved and it’s time to step up purchases before too many people notice and drive the price up in a meaningful manner.

Based on the momentum scores of each stock in our universe and its sector membership we then aggregate, on an equally weighted basis, the scores into a sector composite. 

Analyzing the Current US Equity Market

The current equity market is transforming an emphasis on large-cap Tech stocks to a more balanced representation.

The analysis includes all common stocks with a market capitalization greater than $200 million traded on US exchanges.

• A snapshot of this environment reveals that 50% of stocks are in an Up Trend, showing strong momentum and investor confidence.

• Meanwhile, only 12% are in a Down Trend, reflecting areas of concern or sectors facing challenges.

• The rest are scattered across the stages of Deterioration (14%), Break Down (4%), Improvement (11%), and Break Out (12%), indicating a market in constant flux, with stocks transitioning through the cycles of momentum.

• On balance, the US equity market is positively positioned with a significant number of stocks with positive price momentum.

• The overall technical health of the US equity market based on stock momentum has improved with 73% of our universe in bullish phases (Up Trend, Improving, and Break Out).

The picture is, however, not uniform when we aggregate individual stock momentum stages into broad sector composites. There is lots of stuff under the hood!

Here’s a look a what the current internal picture of the US equity market looks when aggregated into economic sectors.

 There appears to be a dichotomy behind those sectors that are interest rate sensitive such as Financials, Utilities, and Real Estate, and the rest of the market.

Interest-sensitive sectors that had been lagging before the Tech correction have now become the market leaders.

This may be due to the expectation that the Federal Reserve is soon going to be cutting rates but, in my opinion, the catalyst is more due to the over-valuation of the Tech sector relative to the rest of the market.

Here are some other high-level observations:

• Financials, Utilities, and Real Estate now have the highest proportion of stocks in the Up Trend stage as opposed to February of this year. For example, 72% of Financials are in this momentum stage while only 38% of Tech companies are in this bullish phase.

• In addition, when looking at the opposite end of the spectrum, companies in the Down Trend stage, only a small percentage of companies within the Financial, Real Estate, and Utility sectors are represented.

• While only 12% of stocks are in the Down Trend stage, companies with more pronounced growth profiles such as those in Technology, Communications, and Consumer Discretionary have higher than average representation at the moment.

The Big Rotation:

Let’s take a look at the current technical picture relative to what we observed two weeks ago (using July 14 data) before the Tech correction commenced in earnest.

A glance at the change in the proportion of stocks in each technical stage is illuminating and suggestive of a strong market re-orientation away from growth sectors of the market toward more valuation and especially interest-sensitive segments.

Let’s start with the overall market.

• The percentage of companies in the Up Trend stage has increased 18% over the last two weeks. That’s impressive and noteworthy as most times we only see small changes, especially over a short window such as two weeks in length.

• On the flip side when looking at the Down Trend stage we observe that compared to two weeks ago we now have 13% fewer companies in this bearish stage.

• Fewer companies (18%) are also showing up in the Deteriorating and Break Down stages compared to before the rotation started in earnest.

• Key Message: The overall US equity market is becoming more bullish!

Now, let’s look under the hood as we aggregate individual stock scores into their appropriate economic sectors.

• The biggest change from two weeks ago has occurred within the Financial, Real Estate, and Utility sectors. These sectors have become the new darlings.

• Things may not last, of course, but for now, investors are taking notice. These sectors are interest-sensitive. If the Federal Reserve does cut rates in September expect these three sectors to benefit disproportionally (on the upside).

• The Tech sector is experiencing some internal realignment as we now see 12% more companies in the Down Trend stage (slightly higher than the universe average) but all is not doom and gloom.

• The reason why we don’t see more Tech stocks in a declining or bearish phase is that many of the mid and small companies in the sector were not participating in the euphoria of big-cap Tech before the last few weeks.

• Investors are taking a second look at smaller Tech companies and much of the correction has been limited to the glamor, large-cap Tech stocks. In a sense the market realignment has been neutral to beneficial to Tech stocks but the vast majority of the benefit has accrued to mid and small-cap stocks within the sector.

Small-Cap Stocks on the Rise

In the current market landscape, small-cap stocks have emerged as a surprising yet promising area. These companies, typically defined as those with a market capitalization between $300 million and $2 billion, have recently outperformed their larger counterparts.

This trend signals a shift in investor focus, as many look beyond the well-established giants to uncover new opportunities among smaller, at times under-valued companies.

In the last month, the median return for the smallest (in terms of market capitalization) stocks in our universe has been 16%. These are our Decile 1 companies.

In comparison, the median return of stocks in our largest capitalization segment (Decile 10) has only returned slightly above 2%.

The appeal of small-cap stocks often lies in their growth potential, but in the current environment, the resurgence of the asset class has more to do with cheaper valuations.

The Benefits of a Diversified Market for Investors

The recent sector rotation and the broadening of market leadership have created a more balanced and diversified market environment. For investors, this diversification is a significant positive, as it reduces reliance on any single sector or group of stocks, thereby mitigating risk.

A diversified market offers several benefits. Firstly, it can lead to more stable overall market performance. When multiple sectors and types of stocks contribute to market gains, the market becomes less susceptible to sharp declines caused by sector-specific issues. This stability is particularly important in times of economic uncertainty or when specific sectors, like tech, face valuation concerns.

Secondly, diversification opens up a wider range of opportunities for investors. By looking beyond large-cap tech stocks, investors can find value and growth potential in sectors that may have been overlooked. For instance, sectors like financials, real estate, and utilities are currently offering attractive entry points, thanks to favorable economic conditions and sector-specific catalysts. This breadth of opportunities allows investors to build portfolios that are more resilient and aligned with their risk tolerance and investment goals.

Moreover, a diversified market environment encourages better investment discipline. It reminds investors of the importance of not putting all their eggs in one basket and of regularly reviewing and adjusting their portfolios. This proactive approach can help investors avoid the pitfalls of chasing hot stocks or sectors and instead focus on a long-term, strategic investment plan.

For those managing their investments, understanding and leveraging these market dynamics as shown in our Technical Stage Indicator is crucial. It provides a roadmap for navigating different market conditions and ensuring that their portfolios are well-positioned for both growth and protection. By embracing a diversified investment approach, investors can enjoy more consistent returns and, in the long run, a smoother investment journey.

The Big Picture:

• Investors experienced a down week last week driven by negative returns in the large-cap US space.

• US Small Cap Equities, however, were up 3.5%. Over the last month, small caps have rocked to the tune of 10%.

• Commodities continued trending down as oil prices retreated and inflationary expectations continued to decline

• The investment environment remains risk-on. Aggressive asset allocation strategies continue their outperformance. A more balanced US market provides a real benefit to investors with significant equity exposure.

  

  Source: iShares, 7/26/2024

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Disclaimer: This newsletter is not trading or investment advice but for general informational purposes only. This newsletter represents my personal opinions which I am sharing publicly as my blog. Futures, stocks, and bonds trading of any kind involve a lot of risk. No guarantee of any profit whatsoever is made. You may lose everything you have. We guarantee no profit whatsoever, You assume the entire cost and risk of any trading or investing activities you choose to undertake. You are solely responsible for making your own investment decisions. Owners/authors of this newsletter, its representatives, its principals, its moderators, and its members, are NOT registered as securities broker-dealers or investment advisors either with the U.S. Securities and Exchange Commission, CFTC, or with any other securities/regulatory authority. Consult with a registered investment advisor, broker-dealer, and/or financial advisor. By reading and using this newsletter or any of my publications, you are agreeing to these terms. Any screenshots used here are the courtesy of Global Focus Capital and Retirement With Possibilities. The data, quotes, and information used in this newsletter are from publicly available sources and could be outdated or outright wrong - I do not guarantee the accuracy of this information.