We are about 75% through Q1, and how you have positioned with respect to sectors is likely having a dramatic impact on your equity performance. It's been a great quarter so far, with the S&P 500 (NYSEARCA:SPY) up in price by almost 9%. While I remain bullish for the intermediate term, I feel like we could be facing an interim top within the next few weeks. There are several technical indicators I am watching, and I have some fundamental concerns too. On the latter, I am concerned about the big positive dynamic this year of Yen weakening potentially halting or risking the wrath of Europe. Also, all those capital gains taken in front of year-end are likely to lead to some cash-raising in front of April 15th. Finally, we might see some nervousness as we begin to start earnings season in a few weeks.
If the market reverses, I suspect it will be a profit-taking type of scenario rather than the start of something more alarming. In this case, what has gone up the most is likely to be at risk of correcting the most. With this in mind, I wanted to see how the different sectors have been performing so far in 2013:
The ETFs are sorted alphabetically. Before I go on, the left side of the table comes from Baseline, but the last three columns (and the weightings) are derived from Standard & Poor's (registration required). Note that the Technology (NYSEARCA:XLK) index includes not only Technology but also Telecommunication Services, which didn't get its own ETF, perhaps because there are so few stocks in the sector. I have taken a short-cut and used the 85% of the combined sectors that is in Technology for the data on the right. Note also that these earnings growth numbers are probably all at least a little too high - analysts tend to be a bit optimistic!
XLK is the bottom of the barrel, up just 5% this year and only 12% above its 52-week low. I didn't include the data in the table, but if one looks at the last six months, the relative performance has been even worse. While the S&P 500 has rallied by over 8%, XLK has actually declined almost 3%. It's the only decliner of the 9 SPDRs. Similarly, over the last year, XLK is up only 4.3%, the worst sector and almost 10% behind the market.
What's Wrong With XLK?
Anyone who follows the market probably knows about the 800-lb gorilla, Apple (NASDAQ:AAPL), which is stinking up the joint. I wrote about the impact AAPL has on various ETFs like XLK earlier this year. If you happen to like Technology but are afraid of AAPL, I had a recommendation. In any event, AAPL makes up now about 15% of XLK. It is down 19% YTD. If I am doing the math right, it has hurt the XLK return by 3.4%. So, even if AAPL weren't in XLK, XLK would still be the second-worst sector, lagging Utilities (NYSEARCA:XLU). There are 10 other really big stocks. With the exception of Google (NASDAQ:GOOG), they are all S&P 500 plus/minus 4%:
I think that there are some other factors that may be hurting XLK. First, the dollar has been strong all year relative to the Yen. More recently, it has strengthened against the Euro and is now up slightly year-to-date. Compounding this currency effect is the fact that economic growth in the rest of the world has been lagging domestic growth, and Tech is a big exporter. Another factor may be that it has been one of the best performers over longer periods of time. Through the end of February, the 6.45% price return has bested the market by almost 400 bps. The return is overshadowed only by Consumer Staples (NYSEARCA:XLP) at 6.79% and Consumer Discretionary (NYSEARCA:XLY) at 10.3%.
While it's unlikely that XLK will rally if the market retreats, I think that its low valuation relative to other sectors and lack of recent gains will help it to hang in better. In a market shifting to a weaker dollar, Tech could benefit greatly. I think that a rising interest rate environment, should it play out that way, could benefit these cash-rich companies too.
What's At Risk?
The area that jumps out as the most extended and potentially overbought is XLY. This is somewhat surprising given all the concern over the U.S. consumer. This is a diverse group though and includes global media and entertainment companies, Internet retailers, homebuilders and advertising companies. Given that the sector is half as big, it takes 1/2 the market cap to have the same impact on XLY as on XLK. So, here is the performance from the stocks greater than $50 billion:
There is clearly a lot more strength at the top - not a single stock is lagging the overall market. But, looking even deeper into the index, the breadth is pretty good as the average return of the stocks matches the market-cap weighted return of the sector. Here is how XLY and XLK have traded against each other the past two years:
It has been a pretty wide split since September, with XLK declining from a high that dates back as far as 2001 while XLY has powered past the all-time high it was setting when the divergence began.
What About The Second Largest Sector?
I remain bullish on Financials (NYSEARCA:XLF) despite their leadership over the last five quarters. They remain in a strong recovery with a pessimistic PE in my view. It seems like their rally is just getting started:
Notice the blue line at the bottom, as it represents relative strength to the S&P 500. Despite being the best sector since late 2011, it has still lagged the overall market by 8% over the past two years. A longer term perspective shows that there was a long consolidation period after the rally following the collapse:
We have only marginally cleared the top of the three-year range. In the past decade, the SPY has rallied 83% (from what was close to the bear market low in 2003), while XLF has fallen 18%. The valuation of XLF is a big discount to the market, and earnings are recovering. The sector is a bit extended, but I would be careful betting against it.
I happen to be a bull, but not a permabull. I am expecting the "Energizer Bunny" rally to pause, reverse a bit and give those left behind a chance to get in. In that scenario, I see a rotation developing that could benefit Technology, which has been left behind by this rally.
Additional disclosure: One or more model portfolios managed by the author at Invest By Model hold XLK, XLF, CSCO and INTC.