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>>> Tide starts to turn against defensive stocks

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gfp927z   Friday, 05/17/13 10:56:55 AM
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>>> Tide starts to turn against defensive stocks

What nascent sector rotation means for your portfolio

By J.J. Zhang

May 14, 2013


One of the more unusual trends in the current market rally has been the sector-by-sector performance. While most strong market rallies like the one we are currently in are typically driven by cyclicals and growth sectors, the current rally has instead been characterized by outperformance of noncyclicals or defensives.

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As I had pointed out in a previous article, cyclicals typically outperform noncyclicals or defensives during market rallies. Looking at rallies from the last 10 years, sectors such as materials and technology outperformed the S&P by 2%-5% while defensives such as utilities and consumer staples underperformed by 6%-7%.

The current rally has turned that trend on its head as sectors such as consumer staples /quotes/zigman/246134/quotes/nls/xlp XLP -0.43% has returned over 22% since the November low versus the S&P 500 /quotes/zigman/714403/quotes/nls/spy SPY +0.41% at 21% while growth sectors such as technology /quotes/zigman/1475411/quotes/nls/xlk XLK +0.39% are at only 16%.

If you had invested in defensives from the beginning, you’re likely relishing the year-to-date portfolio returns while those in tech have languished. However, within the past few weeks, indications of a sector rotation between the cyclicals and defensives may indicate change is afoot.

Trend changes
One possible reason for the recent outperformance of defensives may be the search for yield as demand for reliable dividend-paying stocks pushes up their prices.

As the Fed’s QE policy continues and other countries such as Japan start their own QE programs, there is a flood of money looking for returns. With bond yields at a record low and the risks of bond prices dropping in the future once interest rates inevitably rise, there are precious few alternatives besides dividend-paying stocks left.

However, reversion to the mean is a very real phenomenon and the valuations and yields that made defensives attractive initially have weakened significantly during the run up.

For example, the consumer staples sector ETF had a P/E ratio of 14 during the November market bottom but is now sitting at 18. Similarly, its trailing yield has dropped from 3.2% to only 2.6% today. In contrast, the underperforming industrials sector currently sits at a low 14 P/E and a 2% yield. The benchmark S&P 500 is at 15.5 for P/E and a 2% yield.

Looking at the weekly gains by sector for this entire rally, the last 3 weeks have seen a reversal of trends. Look at the gain difference between cyclical sectors (in this case, an average of industrials, materials and technology) versus the defensive sectors (utilities and consumer staples): Last week cyclicals gained 1.9% while defensives lost 1.3% for a 3.2% delta.

While cyclicals outperformed defensives at the beginning of the rally by 1%-2% per week, the defensives dominated for the majority of the rally from January to April, beating by 1%-4%.

However, in the last 3 weeks, that trend has strongly reversed with cyclicals now starting to outperform defensives by a significant 2%-3% gain per week. In just 3 weeks, those cyclicals have caught up by almost 7%. However, even with those gains, they are still underperforming both the defensives and the S&P 500 for this rally.

Full speed ahead?
A sector rotation into underperforming sectors is actually in a good sign of a healthy market. A common indicator for market tops is decreasing breadth where the market advance is dominated by a few select stocks while the rest start to drop.

As well, increasing overvaluation in concentrated sectors is another red flag. Rotation of money and interest into the undervalued or lesser valued sectors helps reduce the frothiness of the overall market.

While that does not mean the market rally will continue, especially as we enter the traditionally slow summer months, it is at least a small positive sign.

So what portfolio actions would this suggest? If you’ve been doing portfolio rebalancing or broad market indexing, you’ll likely benefit naturally from the rotation. However, for those who are still highly exposed to defensive sectors or those with low exposure to cyclicals, rebalancing may be an option.

While it’s not always prudent to chase after potential outperformers or jump on bandwagons, the valuation changes due to the now six-month rally do lend credence to at least rebalancing your sector exposure. Doing so will help mitigate mean reversion effects and also allow you to benefit from any sector rotation that have and may continue to occur.


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