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Over the past week, the financial markets have experienced a substantial pullback. This pullback in prices comes in light of a myriad of events driven by the government, currency markets, and the Federal Reserve. Rather than dwelling on the macro forces which affect the overall market, I believe that profits can be gleaned through sector analysis.

Sector Overview

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The chart above shows the performance of every sector of the S&P 500 for the past month. Rather than casting a cursory glance over the entire group, we will briefly delve into the current developments in each as well as provide a trade recommendation. By thoroughly examining each sector, we are better able to arrive at a recommendation for overall market direction.

Consumer Discretionary

The consumer discretionary (NYSEARCA:XRT) sector of the economy is composed of businesses which sell "non-essentials" such as retail and media items. The consumer discretionary sector has experienced a decline of 6% over the past month. This decline is slightly more than the average market decline of 5% and warrants investigation.

Perhaps the largest driver of spending within the consumer discretionary sector is disposable income. The reason behind this is that as individuals accrue greater quantities of disposable income, they will more than likely spend said income on superfluous items, fueling the sector. The chart below shows the discretionary income of the United States for the past 8 years.

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  1. Discretionary income has recently peaked out and is currently in a pullback.
  2. Since the economy is in a temporary period of contracting discretionary spending, I do not believe that investors should hold consumer discretionary stocks.

Consumer Staples

Consumer staples (NYSEARCA:XLP) represents spending on essential products. Essentially, the spending on consumer staples by consumers will not be curtailed unless the economy experiences a very serious contraction. Over the past month, consumer staples have experienced a decline of 6%. This decline is slightly more than the average market decline of 5%.

Since the consumer staples sector of the economy does not experience very wide variation in demand, we can ignore a variety of factors while examining the sector. For example, it does not make any sense to examine consumer sentiment since individuals will not be widely-swayed. The backbone of this sector is commodities. As companies are able to get lower commodity prices, stiff competition virtually ensures that these savings will eventually be passed to consumers. In light of this relationship, I believe that an analysis of the Goldman Sachs Commodity Index points to the overall profitability of this sector.

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  1. Since November of last year, the Goldman Sachs Commodity Index has been in decline.
  2. A declining commodity index tangibly means that the consumer discretionary industry will more than likely be able to increase profits as prices decline.
  3. For this reason, I advocate purchasing consumer discretionary securities.

Energy

The energy sector (NYSEARCA:XLE) has held up surprisingly well over the past few months. Even though WTI, the primary crude benchmark, has declined by several dollars over the past week, the overall sector remains relatively robust. The overall market has experienced a 5% decline and yet energy has only fallen 4%.

Within the energy industry, there are conflicting economic relationships. For example, when natural gas and coal prices fall, electricity producers benefit. Similarly, as crude prices fall, refiners, on average, profit. The existence of these conflicting relationships allows the investor the ability to distance himself from analyzing the individual commodities and rather examine the ultimate driver of the sector: the economy. As the economy betters, demand for energy rises. The most comprehensive measurement of the economy is GDP, which can be seen in the chart below.

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  1. GDP is not only growing, but it has recently experienced an increase in growth rate.
  2. An increasing growth rate implies heightened demand for energy.
  3. As demand increases, I believe the sector will increase and investors would be wise to hold energy shares.

Financial Services

A myriad of publications have exhaustively covered the financial services (NYSEARCA:XLF) industry for the past 5 years. At its most basic form, the financial services sector profits from lending. As (prudent) lending increases, the profits of the financial services sector tend to rise. The proliferation of lending and easy credit has led to a depression of financial profits. As rates have decreased, financial institutions have ultimately captured diminishing profits, leading to subdued financial shares. The Federal Reserve's announcement of tapering the bond buying programs, which essentially depresses rates, is very good for the financial sector. As rates are allowed to rise again, financial organizations will reap the benefits.

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  1. Interest rates, as measured by the 10-year Treasury note, have risen substantially this year.
  2. As interest rates rise, financial institutions profit through the collection of greater payments on debt.
  3. In light of this relationship, investors should consider holding financial shares.

Healthcare

The healthcare sector (NYSEARCA:XLV) has experienced much turbulence over the past 4 years. The politically-charged atmosphere surrounding universal healthcare has led to a volatile stock price and industry. It is my belief that the majority of the changes in the industry have already been factored into the price and a thorough examination of the sector is not warranted at this time. I believe that this is reflected in the fact that healthcare has essentially matched the overall market movement. For this reason, I recommend neither adding nor selling healthcare shares.

Industrial

The industrial goods (NYSEARCA:XLI) sector of the economy is essentially the heavy manufacturers. These firms only make money when significant economic expansion occurs. As previously examined, the overall economy is expanding and doing so at an increasing rate. This expansion will not be enough to drive profits to these firms however. The economy also requires inflation for industrial goods to prosper. If inflation expectations are high, large corporations will invest sooner rather than later in capital goods. The chart below shows the inflation growth rate.

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  1. Inflation is in a period of decline.
  2. Since prices are falling, it is my belief that capital investors will delay purchasing from industrial firms. Investors would be wise to be underweight the industrial sector.

Materials

The materials (NYSEARCA:XLB) sector is much like the consumer staples in that it ultimately depends on the declining price of commodities to temporarily capture profits. Commodity prices have been declining, denoting an increase in profitability of materials-based firms. The market understands this and materials shares have only declined 3% while the S&P 500 has declined by 5%. It is my belief that this relationship will continue and investors should be long materials stocks.

Real Estate

The real estate (NYSEARCA:IYR) sector has been crushed over the past month. The reason for this is quite logical. The Federal Reserve has been purchasing billions of dollars of mortgage-backed securities which essentially drives down the rate on real-estate loans. As the rate on loans declines, individuals are more likely to invest in real-estate. The Fed's announcement of "tapering" its purchases essentially means that the real-estate party is over and normal economic forces will once again prevail. For this reason, I recommend selling real-estate shares.

Technology

The technology (NYSEARCA:XLK) sector has evolved to essentially be any company which deals primarily in electronic-based business. Within the technology sector, there are over 32 different diverse categories. Despite the diversity of companies within the sector, simple economic laws govern profit. Ultimately, the demand for technology is driven by disposable income. As previously discussed, disposable income is currently contracting. For this reason, I do not advocate purchasing technology shares.

Telecommunications

The telecommunication sector (NYSEARCA:IYZ) is currently in a turbulent period. The NSA has been conducting secret surveillance programs and certain companies have participated in supplying information. The ramifications of compromised integrity will be significant. The market realizes this fact, as witnessed by a 7% plunge in technology shares. I do not believe that the market has fully discounted the effect of this situation and there are further price declines in store for technology stocks.

Utilities

The utilities sector (NYSEARCA:XLU) is basically composed of gas, power, and water firms. These firms are typically very stable and offer steady dividends for the risk-averse investor. The utilities sector is unique in that it is sheltered between two warring economic forces: commodity prices and economic growth. As commodities fall, the utilities sector is able to profit due to a decreased cost of input. As the economy rises, the sector profits from heightened demand. In light of these opposing economic forces benefiting the industry, I believe that investors should hold utilities shares.

The Trade

It is only after thoroughly examining the economy that we can arrive at a comprehensive market view. In the table below, I have summarized my belief about the direction of different sectors.

Individuals could traverse through the landscape of calculating a weighted recommendation from these market views, but I believe a simple additive method of investing works fine. I see 4 sectors of the economy rising and 5 sectors of the economy falling. In light of this analysis, I view the economy as being in overall decline for the near future. To comprehensively profit from this analysis, I recommend shorting the S&P 500 (NYSEARCA:SPY).

Source: Short The Market: It's Simpler Than You Think