In the wake of my Great Rotation publication (see Everything you need to know about the Great Rotation but were afraid to ask), it’s time for an update of how global regions and US sectors are performing. The short summary is the change in leadership of global over US stocks, value over growth, and small caps over large caps are still intact.
While the long-term trends remain in place, some tactical caution may be in order in certain parts of the market.
Global leadership patterns
For the purposes of analyzing change in leadership, I use the Relative Rotation Graphs, or RRG charts, as the primary tool for the analysis of sector and style leadership. As an explanation, RRG charts are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.
The RRG analysis of global regions is clear. Avoid US equities. The only regions in the bottom half of the chart are US indices.
A more detailed analysis of relative performance against the MSCI All-Country World Index (ACWI) shows that the S&P 500 and NASDAQ 100 losing steam, major developed markets like Europe and Japan trading mostly sideways, and EM xChina the best relative performer. EM xChina’s strong relative performance is mainly attributable to that region’s high cyclical exposure, though the region may be vulnerable in the short-run owing to the extended nature of the recent rally.
Sector rotation analysis
The RRG analysis of US sector held few surprises. Large-cap growth sectors such as technology, communication services, and consumer discretionary (AMZN, TSLA) were in the weakening quadrant. Defensive sectors, such as consumer staple, utilities and real estate, were in the lagging quadrant owing to the strong market rally since the November Vaccine Monday rally began. Unloved value sectors such as energy and financials are in the leading quadrant.
A closer examination of the two leading sectors, energy and financials, reveal some key differences. Both large and small cap energy stocks are beating their respective benchmarks and showing similar patterns (top panel), but the degree of outperformance of small to large cap energy (bottom panel, green line) lags the relative performance of the Russell 2000 to S&P 500. If energy stocks are to remain market leaders, there may be some opportunity in small cap energy.
The analysis of large and small cap financial stocks tells a different story. While large cap financials have begun to recover, small caps have not shown the same relative performance pattern (top panel). The yield curve has been steepening, which should be positive for banking profitability, but the lagging leadership of small cap financial stocks is a blemish for the sector.
The big surprise from the RRG chart was the deterioration in relative strength seen in cyclical sectors such as materials and industrials. In theory these sectors should be performing well as the global economy recovers from the pandemic. Instead, the relative performance of cyclical sectors and industries have begun to flatten out.
A cyclical pause?
Signs are growing that the expectations of a cyclical recovery has grown too far, too fast. In a recovery, companies with high financial and operating leverage should perform well, and indeed the high operating leverage basket has rocketed upwards against the S&P 500 since Vaccine Monday. Cyclical stocks may have risen too far, too fast.
The global cyclical recovery trade appears ready to take a breather. Callum Thomas
observed that industrial metal PMIs are starting to roll over, even though readings are still strongly positive.
However, any pause in the cyclical rebound is likely to be short-lived. China has been leading the global recovery. Despite the recent pause, the PBoC has injecting liquidity into the financial system, which should boost the cyclical sector within the next few months.
I am monitoring the relative performance of Chinese material stocks. This sector has traded sideways relative to other global material companies. While this is a sign that economic momentum is losing some steam, it will also provide a real-time alert of improving economic momentum from China.
What does this mean for the stock market? First, investors should relax. The rally is likely due for a pause but the bull cycle remains intact. The current advance in the Dow is consistent with past historical experience since 1900.
From a sector perspective, investors should focus on value stocks. The relative performance recovery of large and small cap value, however they are measured, are intact.
In particular, the energy sector holds promise. This sector has become the smallest sector by weight in the S&P 500, indicating its unloved status. Even within the commodity sector, the crude oil to gold ratio is depressed. Energy stocks are now the new tobacco – unloved value stocks. Their recent relative strength recovery could be a signal of a turnaround for this sector.
From a global perspective, investors can also consider value candidates that have begun to recover. In the developed markets, small cap UK stocks could be a source of outperformance, now that the uncertainties of Brexit have been resolved.
Within the emerging markets, EM xChina has been exhibiting strong relative strength, though it is a little extended and could see a short-term pullback.
However, the analysis of fund flows show that EM xChina equity flows are net negative for 2020. These stocks are still under-owned, indicating substantial potential for outperformance.