Sector leadership review: Bear market vibes?

Now that the 2s10s yield curve has un-inverted, a review of sector leadership is showing bearish vibes. In particular, the relative performance of defensive sectors is turning up.

I conducted an extensive sector and factor rotation review to determine the extent of the damage.

The RRG chart below shows the rotation of equal-weighted stock sectors benchmarked against the equal-weighted S&P 500 as a way of mitigating the outsized weights of the Magnificent Seven and other megacap growth stocks.

My main takeaways from this analysis show that the top half of the chart, which is the leadership or emerging leadership, consists of defensive sectors, financials and communication services. By contrast, the bottom half is composed of technology and mid- and late-cycle cyclicals. Ominously, this is what a market top looks like.

 

The RRG chart of small-cap stocks tell a similar story. Defensive sectors and financials are in the top half of the chart, while technology and cyclicals are in the bottom.
 

Does this mean a bear market is about to begin?
 

 

A benign interpretation

A more detailed review of factor and style rotation reveals a more benign explanation. The bottom half consists of the high-octane factors of price momentum, IPOs and high beta, with high quality the only exception to this theme. While speculative growth is in the improving quadrant, it’s rolling over quickly and likely to be destined to fall into the lagging quadrant in the near future. The top half of the RRG chart is made of low volatility, dividend growth, buybacks and small caps, which are value-oriented themes. Even though the Russell 2000 is normally not thought of as a value play, its forward P/E is far more attractive when compared to the S&P 500.
 

 

The RRG chart of large- and small-cap growth and value styles tells a similar story. Large-cap growth is in the bottom half of the chart and speculative growth is rolling over. By contrast, all the other groups are in the leading quadrant, namely large-cap value, small-cap value and growth.

This analysis points to a more benign interpretation of a tanking Magnificent Seven and other NASDAQ growth names that’s distorting the sector rotation analysis.
 

 

Using the NASDAQ 100 as a proxy for large-cap growth, we can see that the index topped out in early July. It’s now testing a relative support zone as relative breadth deteriorates (bottom two panels).
 

 

In fact, the rotation from growth to value is broadly based and it can be seen across all market cap bands and internationally (red dotted line, top panel). More importantly, the rotation can be seen in the relative dominance of small-cap value over large-cap growth (bottom panel).
 

 

A similar theme of a rotation from large-cap to small-cap leadership is evident not only in the Russell 2000, but also within the technology dominated QQQs.
 

 

In conclusion, a preliminary review of sector leadership is flashing bearish vibes and defensive sectors are dominant while technology and cyclicals lag. However, a more nuanced review of factor and style leadership argues for a benign explanation of a broad-based rotation from growth to value and from large caps to small caps.

I am inclined to embrace the benign view. Both the S&P 500 and NYSE Advance-Decline Lines recently reached all-time highs. Bear market tops don’t behave this way. As a reminder, I downgraded the Trend Asset Allocation Model from bullish to neutral in late July and I stand by that view (see China Slowdown = Reduce Risk). This is a correction that should be bought.