Layers of an Onion- Sector Rotation

Let's talk about the layers of an onion. This market and an onion have many things in common. I'll let you figure out the most obvious similarity... however, here at the hot off the press, Yellow Rose Street Beat, we are not into sniffling, complaining, or spitting out explicatives at 'achhh... ze guhlie men in Sachramento'...

This market builds character... and man do we have character by now... but this market also builds much more... it forces us to sharpen our tools, hone our skills, to be the very best we can. How about we laugh in the face of all this teasing banter? This market has been a learning experience for many, including me for sure, and as I learn and grow I say to myself thinks like....’it's ok to buy financials that are worth almost nothing and to short sell fertilizers trading at half their worth'.... it's ok to buy financials that are worth almost nothing and short sell fertilizers trading at half their worth'.... no really... that is what the smart people are doing...

So let's disabuse ourselves of foolhardy assumptions, such as the one that stocks follow earnings (well they still do in the long-term... but right now the Street could care less about that...) and try to figure out what we really want to know... How do we get better, how do we adapt, what do we need to do to soar in this market? And... the thought goes... if you can make it here... you can make it anywhere... I have used hedging, I have continued to study technicals, I have learned more and more about charts, and I have sought out means upon means to keep the investments in my pocket. I have to admit I was holding my own quite well until the potash stocks imploded (despite tripling and quadrupling earnings and guiding... never mind....).

Luckily, by hedging and going short and acting in a manner that is fully irresponsible and goes against everything I once thought I knew about the market I have been able to cushion the blow a jus' a little bit. Still, I was left searching for some missing pieces in my techniques. Actually, I am always searching for them... however with the events of the fertilizer stocks I realized that at least one key piece was missing... You are the lucky benefactors of my sole soul search... if you will... so let's now delve deeper into the onion...
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An onion has many layers, and in the stock market an individual stock or even ETF is in the very center of the onion. To try to look at the stock without paying attention to the layers can be a costly mistake. The outer layer of the onion is the overall market. A nice summary of long-term, intermediate-term, and short-term market trends was covered in the post It PAYS to be Trendy. To recap, according to Dow theory, there are three types of trends:

1. Long Term Trend (around a year and longer)
2. Intermediate Term Trend (several weeks to several months)
3. Short Term Trend (less than several weeks)

The long-term trend defines whether the market is a bear market or a bull market. Victor Sperandeo (Trader Vic- Methods of a Wall Street Master) says it best when he writes that during the early to middle stages of a Bull market it is time to be an investor (think buy and hold or some variation of this), while during the end stages of a bull market and during bear markets it is optimal to be traders. Trades can last for several hours or several months... but the idea of holding stocks and leaving them alone indefinitely is generally a recipe for giving back your gains. That is, unless you have a very long time horizon.

Within the long-term trend it is also important to be aware of where the market is in terms of the market cycle.... also described slightly differently as a business cycle. At this point I would call the market in the distribution (or early recession) stage. We have not yet seen dramatic decreases in earnings estimates across the board (except in financials) and we have not yet witnesses anything close to capitulation.

The intermediate trend, I believe, is the most important one to pay attention to for purposes of trading/investing in a bear market. However it needs to be placed in the context of the long-term trend. Generally speaking, we want to be mostly short if you are in a down trending market and mostly long if you are in an up trending market. This, of course, is a generalization. And there in lies the rub. Some stocks can be in an upward intermediate trend while others are in a downward intermediate trend all in the same market. This comes to the next layer of the onion... a missing piece here if you will. This one is extremely important and can save and/or make you tons simply by paying attention to it.

The market as a whole is like a big pendulum that has various cycles within it. This includes elements as broad as the market stages defined above to as short as the minute by minute oscillations in stock prices that traders generate every day. Within these two extremes lie many, many types of cycles. One of these cycles includes the often massive movement of money from one category of stocks another to another to another... etc. What I am talking about here is sectors, and specifically, sector rotation. Within the context of the overall market we all know that certain sectors can be hot and others cool. The question is: how can this knowledge help us?

A. Let's first look at two general approaches that are useful to consider...
1. Top to bottom approach. This entails looking for at the sector level first and then finding ETFs and/or stocks that might fit into the bigger sector picture. Once you identify a sector that appears to be heating up (more on this later) you can first and foremost look for ETFs like QLD, UYG, RLX, DIG... etc. ETFs allow for sector exposure while distributing risk among many companies within the sector. They also allow you to use leverage (the double short and double long ETFs) and to go short. Proshares has nice list of sector ETFs to choose from. I would take a look at their website first. There are many other companies that also offer excellent sector ETFs. Next, you can look to choose specific stocks that may be particularly appealing within the sector that is being favored. For example, if technology appears to be heating up, it may then be a good idea to look for technology stocks, such as RIMM, AAPL, MRVL, etc. The reality is that in many cases if the sector is doing well you may already have the odds in your favor when you search for the right stocks. It's like a pre-screen. The stage is set to potentially identify successful companies... at least as long as the sector remains in favor. From there you still need to do the due diligence, of course, to find which specific stocks may be the best for you.

2. The bottom to top approach. The other way in which identifying sector rotation can be useful can be categorized as the bottom to top approach. I really feel that almost everyone involved in stocks and/or ETFs should at least consider this before investing and/or swing trading on the long or short side. The idea here links directly with the concepts of Dow theory, market trends, etc. When investing in most stocks it is important to know what the overall market is doing. Few stocks live on an island. Further, as I painfully found out with the potash stocks, even if stocks are just blowing the cover off of the ball and guiding higher, and even if the overall market is in a trading range (not in panic mode)... and even if analysts are raising the price targets... and... you get my point... if you don't take sector rotation into account you can get fried... at least in the intermediate term. In certain cases the big money managers have already decided that money is going to move... and while in some cases earnings can change their minds, in other cases nothing may matter. The bottom to top approach entails employing a fairly straightforward run-through:

• Find a stock you love. (to either short or go long). Do the DD... use fundamental and technical analysis, charts, intuition... etc. The stock is the start point.
• Take into account the overall market trends... the macro picture
• Now... a third step take a look at the sector your stock is in and/or stocks that have a relationship and may trade together with the stock you are interested in. You don't have to make a decision based on the sector or on related stocks... in many cases it may be wise not to... but you should at least be aware of what the sector is doing and what it might do next. This provides a framework that may help you understand how and why your stock is likely to react to news, earnings, etc. in the marketplace.

The idea is to place your stock in a larger context. After all... the stock you are interested in is encased in many layers of ze onion...

B. Identifying hot sectors, sector rotation, and most importantly, where the big money may be going next.
Naturally, in order to put your stock or ETF in the context of sectors it is imperative to interpret which sectors are hot, which are not, and more importantly, which sectors may be the next ones to heat up or cool off. Really what you want to do here is trend analysis... not of the overall market... though knowing theses general trends is the first stop for sure, but in this case trend analysis of specific sub segments of the market. The goal is to see where the trend may be taking a certain sub area of the market. In addition to this, an alternative and/or complimentary aim may be to try to predict well ahead of time where a trend that has not even started yet may show signs of lighting up. Getting into a strong trend early is as good as Gold.

How about buying POT when it was at 30 in '06... or MOS at 10... or ANR at 40 in January '08 or SKF at 100 a few months ago (May).. which peaked at 200 in the middle of July.

We are not talking about small fish here.

Last spring, after the huge run in the market, I mentioned that I was looking towards the weak segments of the market, namely financials and housing, to show signs of decline. This is described a bit in this post... where I also postulated that we might see a stock decline in the summer followed by a rebound going into the election (stocks go up particularly into the months leading into the election... the computers may be all over this).

I knew the fundamentals did not support the rise in the market that we saw in the spring. The rally was unsustainable. I was watching the sectors in which the managers were saying to themselves..."I can't believe I just made trading the long side of these stocks at these prices work.... God Bless America". As the weak sectors were the leading indicators for the market decline in the fall it made sense that a similar pattern could emerge in the summer. I turned out to be correct... and this knowledge helped save me, and potentially my readers, from getting caught on the long side when the market turned. (If interested take a look at the post: This is Why it Pays to try to Understand the Markets). The fundamentals, historical patterns, and the looming 200 moving average, allowed me to then look at the charts for early signs of a new trend. Defense is the best offense. I played solid defense here. For those who were able to catch the early trend in the financials sell-0ffs the combination of defense and offense... that is... selling off long names from the spring and taking gains, AND going short financials, the benefits were staggering. I was considering going short in May when SKF was trading around 100... but at the time I was not yet as familiar as I am now with the significance of Bollinger Bands, island reversal patterns, bounces off of the 200 moving average, and other technical indicators that are so important in this market. I promise you that there were traders out there that reaped these huge rewards.

And so the search to learn and improve goes on... and the 'Rose' tries to chronicle the progress...

All this being said, let's not kid anyone here. One of the most difficult things to do in the market is to correctly identify early trends. It cannot be done accurately every time, but there are some techniques out there that may really help in this regard. This market, more than any, separates the men from the boys and the women from the girls (hey there is no sexism or chauvinism at the 'Rose' ;) ).

The Yellow Rose Street Beat is meant to be a guide to help take us where we want to be. So let's look at some methods that may be useful in identifying sector rotation and taking advantage of it:

1. Compare sector ETFs using charts.
This is so easy and obvious it may sound stupid... but often the simplest formulas and concepts can be the best. Just take a look at perhaps the most beautiful formula in the world... just a few symbols... E=MC^2.!

Just go to yahoo finance and do a several month, or year, or week, or whatever you are interested, comparison chart of various sector or sub-sector ETFs. There is so much money in the market that unless a large portion is going into bonds or cash (still rarely that much) it means that if one sector or type of stock is selling off something else must be going up. When oil and commodity stocks started to sell the money had to go somewhere. Guess what... the talk of "lower oil is fueling the stock market" is true not because $120 or even $100 oil will bail out the economy, though it may help a bit, but because the money flowing out of oil and commodity stocks (have I ever mentioned the potash fertilizer stocks...) had to go somewhere else. Had to. Did. But where did it go?

Take a look at this Chart. Oil, which as I provided an article about on this previous post, I believe, had been highly manipulated on the London ICE (you know I wrote my congressman at the time, Henry Waxman, about this... and he wrote back to me... just as he has in the past... perhaps I'll post the letter on here at some point...). I do not believe it was a coincidence that oil peaked around Memorial Day, stayed high right until just before Independence Day, and then fell off a cliff. The oil demand may be due to the 'burgeoning demand' in China but somehow the prices still correlate with the traditional American driving season...

Anyway... This chart shows some very interesting features. The first ETF to start to go up just before commodity stocks declined was RXL... the health care stocks. I do remember hearing back in May and June that serious investors were starting to look at health care stocks. I think that health care as a sector made a lot of sense... commodities provided a bit of a safe haven from the weakening dollar as Ben lowered interest rates and tried to bail us out of this mess... then when oil and food, among other things, forced Ben to stop lowering rates the financial stocks had nowhere to hide (I wonder if the companies that may have been driving up oil were also the ones shorting financials when they started falling in May... we'll never know...)... and then as oil was ready to decline we were still too early to get revved up for the Xmas buying season (Tech, retail, consumer services)... so health care seemed like a good place to be. To be certain, health care is one of the few areas of the market that has tremendous earnings promise going forward here. However... did it suddenly gain all of that promise from June until now? ... do you see what I am talking about ?

In fact... I had been looking at health care all spring because health care 'goes up in a recession'... but according to the market we were not in a recession in the spring and if you look at RXL it really remained down to flat all the way until a bit before oil started it's decline (coincidence?). Right around the time oil stocks really start to drop we begin to see the moves into technology stocks (QLD), which tend to do well due to Xmas buying season and perhaps some back to school. We also see a move up in consumer stocks... again back to school and Xmas... although as much as anything commodity money had to go somewhere...

It is also interesting to note the correlation between UYM, DIG, and companies like POT. The charts look eerily similar... clearly there was a massive movement of dough in a consensus-type, ask questions later, kind of manner... One other thing... as I mentioned on the POT conference call post, there were no "great job guys" types of statements. Instead, nothing but question after question about demand destruction. And then the analyst downgrade in the face of unbelievable earnings and guidance... (Sounded really dumb)... but it seems clear, upon reflection and what happened next, that the money managers had already decided that they were going to take their gains from the huge run up in commodities and that they were looking for some reason to justify this... ("Mr. Doyle... is it true that the credit crisis has caused more and more investment bankers to consume hard drugs and hence decrease their need to eat... resulting in the outside chance of the potential for possible demand destruction for potash?") The overall point here is that trends matter not only in the overall market and individual stocks but in sectors as well. One way to identify these trends is to compare sector ETF charts...

Just added: in my research I came across this chart...

Also, here is an extensive list of sector ETFs from Claymore. This also allows you to refine to sub industries such as water companies, wind, solar, etc. etc. etc. etc. Here is a useful article on ETF trend divergence.

2. Check out market carpets. Market carpets show the price patterns of a group of representative stocks. This can be two days, a month, a week, or a number of other settings. Of the market carpets I like the sector carpet the best. Market carpets can be found by going to stockcharts.com and looking at the left tab of the page (where stock screens can also be found). Click here to go directly to the page. I like to use these carpets to get a sense of how the sector has done... and by adjusting time frames, to see how this pattern might be changing. A look at the one month shows how badly energy has been beaten up... and also shows that health care has performed well.... Note though that in the past few days health care stocks have been flat... after the up trend... this may signify that the heavy run is over... and to keep gains or possibly go short health care. This made me look at RXL, and indeed it is setting up for a nice short... and it did fall a little. Note that the WSJ also has a free market carpet page here.

Just as importantly, it helped me to be aware of my CMED charts. After looking at the charts and the sector and the run they both had had I decided it was time to sell... this was covered in much more detail on this recent post.

3. Read articles, listen to conference calls, etc.... see if you can pick up from the money managers where the money might be heading next. Then use the charts to confirm or deny...

4. Many more... I will add them here if apropos and if/when I come across them.
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C. Sectors, historical data, anticipation, and more
Now I want to talk a bit about market cycles in general and some ways that you may be able to anticipate sector movement before it happens or as it is beginning to occur. I strongly believe that historical data, such as commodities tend to go up in the early part of recessions, oil tends to move upwards going into the US summer driving season, bear markets tend to last x years on average, and many many many other statistical data points are being used, in part, to help determine the movement of money flow in this market. While we can never have the information that GS or MER has at their fingertips, nor do we have the inside track on what they or their computers are thinking, we can try to establish a basis of understanding that might give us a glimpse into what they are doing and what they are likely to do next. The idea is to then try to find evidence to back this up using the methods described above.

In doing my research I came across three major categories of potentially predictive sector rotation, based on historical precedence:

1. Calendar associated
2. Business cycle associated
3. Geographical

1. Calendar
Calendar associated sector rotation is perhaps the easiest to see and understand. For example, energy stocks and the price of oil usually climb in the spring and move down in the autumn. As I mentioned on the previous post: Building Your Arsenal, this knowledge allowed me to purchase COP in October 06 for under $60 and then flip it around in the summer of 07 for a very nice gain. The logic behind the movement in energy stocks most likely comes from the seasonal demand for oil in the US. Since money managers have to worry about quarterly reports, holdings, etc... they may give up a great name on the cheap. That's where you might step in to take full advantage.

The typical rise in technology stocks starting around mid-July to August and extending through January represents another example of what I am talking about. Notice that the chart of QLD has come up quite nicely in recent times. It bounced off of the 200 SMA recently but is now basing below that. If QLD, or it's underlying index, the Nasdaq (COMPQ on stockcharts) penetrate the 200 SMA and stay above it, there may be a nice run in this ETF and in the stocks that make up the ETF. This is something to watch for right now. Whether you are on the long or short side of it.

The January Effect is a term that describes that stocks tend to do particularly well in January. Especially small cap stocks. As a general rule, this would make UWM something to look for early in the year. Although not a sector rotation, the Santa Claus effect describes the rally that often occurs during the last week of the year... and one should be aware of the sell-off that often occur in December as mutual funds sell stock to distribute yearly income to their holders.

2. Market Cycle Based
Many of us know that cyclical stocks (stocks whose companies depend on the expansion of the economy) tend to do better in bull markets and worse in bear markets. Secular stocks, such as utilities, health care, etc... those that are less dependent on economic growth, tend to outperform the market in down turns. This makes logical sense from an earnings perspective. You might just think... the earnings will take care of themselves... we know that jewelry store chains and other retailers are going to hurt in a bear market so we sell, and we know that utilities are going to do relatively better, so we buy. The problem with this philosophy is that, as we have all seen, there isn't necessarily a direct correlation between earnings and stock movement in the intermediate term. Look at the chart I showed above on the sector SPDRs. Is there a reason that utility stocks were suddenly getting poorer? What about the rise in financial stocks in the spring? Certainly that had to do somewhat with yet another historical correlation, lower interest rates and higher performance of financial stocks, yet the earnings certainly didn't justify the moves. The point is that success in a market like this requires that investors pay attention to where the money is going... Then they can choose a strategy... try to go with the flow, try to pick up a change in flow as it is just happening, take advantage of sell-offs in one sector to hold until that sector comes back up... or a number of other strategies... or don't change investing style at all but be able to put what is happening to their holdings in context. In a sentence: Knowledge is power.

Let's look at the eight widely accepted sectors: (source-Investopedia)

-Industrials/Basic Materials -
-Consumer Durables/Staples
-Consumer Cyclicals
-Technology
-Healthcare
-Financials
-Energy
-Utilities

All except for Consumer Durables/Staples, Utilities, and Healthcare are considered cyclical.... The rest are secular (non cyc). There is tons of historical data out there which shows which sectors are likely to go up or down in each part of the market cycle... i.e. in early to deep part of a recession health care tends to do well. I don't have time to go into this in depth here but perhaps it is worth it for you to think, based on where you think we are in the recession, which areas may do well. Then, as always, confirm this on the charts and/or market carpets.

Conversely, the fact that health care has done so well may tip you off to the fact that perhaps the recession is not 'almost over'. You can look at things from both sides... as a means to confirm or deny larger macro pictures. Once you understand what is going on overall, or at least have a grasp on this, charts, fundamentals, and other confirmations can then hopefully help you pick the winners.

3. Geographical
Money often flows not only to certain sectors at certain times but also into and out of certain global geographical areas. Money may heavily flow into China, or Brazil, or Eastern Europe, or the US, or a whole number of countries and regions. One way to pick up on this is to look at ETFs that track ADRs. Is money flowing into China? Check on FXI or its counterpart, FXP (short). This is one of the most complete international ETF list I could find. You can flip through some of these when you have time and see if there are any trends on the long or short side.
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D. Some pitfalls to be aware of
I do want to mention some words of caution when it comes to depending on sectors too heavily. Chasing sectors can be an exhausting and fruitless game. That is not what this post is about at all. On the most basic level, I will say level 1, you should simply be aware of what the sector your stock is in may be doing. Awareness . Level 2, should you choose to venture there, would essentially comprise of trying to use trend formations to enhance returns. Ideally you would identify an early move into a sector, await confirmation, and then use stops (or watch the stocks carefully) in case the sector/stocks in the sector started to fall. The beauty of trends is that you can join a trend that has already been established, provided that you use stops in case the trend turns against you.

The biggest risk of relying on sector rotation is therefore that trends may change... sectors may turn... When one sector is in favor and a leader of that sector (AAPL for e.g.) misses earnings or guides lower or whatever the whole sector can be hit. Thus, it is important to pay attention to the earnings of sector movers. Also, a group of stocks that trade together, such as commodities, may suddenly turn if the perceived leader turns (like oil). It is important to pay attention to three things here, among others:

• Confirm that a trend really is in place
• Look at the sector leaders.
• How long has the trend been in place? In driving they call a light that has been green for a long time a 'stale' green light. The sector trend may last for much longer than you expect. However, the longer it has lasted the more important it is to look for signs of weakening trends. (Note that the Wilder ADX line is an indicator of trend strength. This goes beyond the scope of this post but you can do further research if interested.)

It is also worth noting that if we are wrong about sector rotation we can miss moves by getting out of a stock (or covering a short) too early. This is the delicate balance between staying too long and risking stock loss and exiting a move that still has movement in it. For example, I first bought POT at 183(a small position) in the spring and I sold at 186 because I thought that sector rotation was coming. It did... the stock fell to 175 for a second and then shot back up. Here is where confirmation, such as a break below major moving averages, a move of the stock to the lower Bollinger Band, a succession of lower highs, etc. can be useful as confirmation. Once POT moved back into trend formation it became a buy again... With POT I re-entered the stock above 200, and it stayed in the continued trend formation.

I wrote this post, in part, because of the consequence of I ignoring the downward trend from 240 to the 215 level. With earnings like this, and guidance like this coming through as I expected, and yet the sell-off anyway... what was I missing...? How could I, and you, learn from this market action to be better in the future?

Ultimately, everyone should be a bit wary when they get into a chart that has gone up enormously. However, if you had been able to get into POT at 120 you also would have been getting into a chart that had gone up and up... and you could have doubled up in a few months... so what is the difference here? Certainly not earnings. POT is growing earnings more quickly then the stock price is rising and according to the CEO of POT and the team at MOS there is no demand destruction in sight. The distinction is that from 240 down the sector rotation was for real.

Confirmation signals in the charts, as mentioned above, could be used to identify this. The downward movement in oil, which was not present earlier, was a second indicator. Third, in retrospect the movement below 180 was an early sign that the trend might be losing steam. It was as if at 180 everyone paused and asked if the trend was over... the answer was no... one more run up and then take the enormous gains and rotate.

Please note, as an aside, that fundamentally I am still very much behind the potash stocks... in the long term upwards earnings and guidance revisions are among the most reliable indicators of upward movement in stocks... along with great valuations. I still hold all my longs. I just go short at times along with these longs as trades...
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E.Tying things up
As a whole, I guess the most significant point of this post is to generate awareness that can later be used as a foundation for your success... to find where you stand among the innumerable layers of the onion... and use it to your advantage. This post just gives you and I one more weapon for our arsenal. The major houses have it... we should, at least to an extent, have it as well.

For your further edification below are some links and references that may help. For me, sector rotation was an area that I needed to move from- 'I kind of know what it is' to- 'I at least have a basic idea of how it may work and how it might be used to succeed.' This is much more the beginning then the end of the learning journey. However... I want to show how it has paid off and may further pay off and can for you as well.

• CMED (discussed on a recent post)
• A potential look at QLD and even more so caution regarding QID unless QLD fails the 200 and goes back down
• The potash fertilizer stocks... had I understood this more extensively in I would have been a bit less aggressive at the 215 region in POT and the 130 region in MOS. I still have not sold any of my longs and won't at these ridiculous prices. Still, I would love to have that cash available for when the chart confirms a move up. If the best fundamental story in town is influenced by rotation then the topic is at least worth knowing about...

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The closing pieces...

Jim Cramer, despite being often known in my mind as Robin Hood's Roger Clinton, is a Harvard graduate and remains one of the most successful hedge fund managers of all time. While I would never buy buy buy or sell sell sell to the frenetic lightening round beat or accept his claim, with out extensive work, that Bear Stearns would be 'just fine'... I do respect a lot of his insights, knowledge, and ability when he focuses on feature spotlights on his show and when he broaches how he managed his own money and his clients' money. You can never mention his name without ado so now that I have I can say... without further ado... Here is Cramer on the importance of sector rotation.

Investopedia on Sector Rotation
Here is a good link
Biotech sector is hot
Blog on Sector Rotation
University on Sector Rotation

THE ONION

"The Yellow Rose Street Beat" is for informational purposes only. It does not give investment advice.