Bull Market Sector Rotation: Relative Strength and Performance Analysis

by: Erik Wright

As an investor it is important to be positioned in the best places possible to take advantage of the best returns that can be offered. Many of us have come to know the strategy of sector rotation, where an investor should position his investments based on the best sectors in the market at a certain point in time. Although many among us have learned to be well diversified to protect ourselves against sector specific risks, the ultimate investors should hypothetically be positioned in only the best sectors which in turn would lead him/her to beat the market in all occasions. Although choosing the best sectors is not always easy and I would not urge anyone to put all of their money in one sector, the following analysis will demonstrate a certain perspective on analyzing sectors based on sector specific ETFs and their relative strengths. The measures that will be analyzed are the RSI (14), the MACD (12,26,9) as well as the year to date performance of the specific sectors.

The Relative Strength Index (RSI) compares a particular security against itself. It compares the relative strength of price gains on days that a security closes up with the strength of price losses on days that a security closes down. A market should close strongly when it is rising and weakly when it is falling. When a market remains above or below 50 for extended periods of time, it is generally considered to be trending. The standard ranges for oversold or overbought are above 70 for overbought and below 30 for oversold, which are strictly used as warning signals of overbought and oversold conditions and a stock may not necessarily switch direction even if it is beyond 70 or 30. Confirmation of a reversal should always be noted before entering a position based on these measurements.

The moving average convergence-divergence (MACD) indicator is probably the most popular indicator for tracking momentum and conducting divergence analysis. By taking the difference of two moving averages, you are measuring a shift in trend over a period of time -- in other words, measuring momentum. The standard MACD parameters measure the difference between a 12 and a 26 period exponential moving average. That difference is then smoothed by a nine period exponential moving average called the signal line. The basic MACD signal is given on crossovers between the MACD line (the difference between the 12 and 26 day moving averages) and the signal line (the smoothed moving average of the MACD line). Buy signals are given when the MACD line crosses above the signal line; sell signals are given when the MACD line crosses below the signal line. Bullish signals can also be seen as the MACD line crosses over the center line or zero line as well as the inverse for bearish signals. The momentum of the trend can also be interpreted through the difference between the two exponential moving averages shown by the MACD histogram.

Although the market could be broken down into many more different sectors, I have taken the nine basic sectors analyzed through SPDR sector ETFs for healthcare (NYSEARCA:XLV), energy (NYSEARCA:XLE), financials (NYSEARCA:XLF), utilities (NYSEARCA:XLU), consumer discretionary (NYSEARCA:XLY), consumer staples (NYSEARCA:XLP), technology (NYSEARCA:XLK), materials (NYSEARCA:XLB), and industrials (NYSEARCA:XLI).

The following chart depicts the year to date performance of each of the different sectors in comparison to the S&P 500 depicted through the SPY ETF.

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As seen above, the major outperformers are the energy sector (XLE), followed by the industrials sector (XLI). The worst performers are the utilities sector (XLU) followed by the consumer staples sector (XLP). Many of the other sectors are fairly close to the S&P 500's performance. The relative strengths of each sector based on the charts will be described in more detail below.

Energy (XLE)

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The energy sector has the highest RSI (61.84) among all sector and was also by far the best performing sector year to date. The high RSI demonstrates the sector's strong bullish momentum and also demonstrates it is not yet considered at overbought levels. The MACD is also showing a positive short term buy indication on the sector with the MACD line crossing over the signal line (black over red). As well, the MACD line is above zero which tells the trader that the 12 period exponential moving average is trading above the 26 period exponential moving averages and seems to be rising which demonstrates another positive bullish momentum indicator. People seem to also be playing the recent drop in the sector's momentum as seen in the graph and are picking up the strong sector on its weakness. Most of the sector's strength has been attributed to the rising oil prices which has benefited many of the oil exploration and production companies in the sector.

Consumer Staples (XLP)

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The consumer staples sector has the second highest RSI (58.32), also demonstrating a bullish momentum that the sector has been experiencing recently. Contrary to the energy sector, the consumer staples sector was placed 8th out of the nine sectors in terms of year to date returns. As seen by the MACD line being below the signal line as well as dipping below zero, the sector had experienced much more fluctuations into periods of bearish momentum. However, recently the MACD indicator is showing a very bullish signal as the MACD line crosses over the signal line as well as rising over the zero line. The recent bullish momentum in the sector could be explained by the uncertainty portrayed by the Japan crisis, Libya, U.S. recovery doubts, as well as other worldwide concerns which have pushed investors towards "safer" investments such as consumer staples which notably have more safety in terms of business operations and higher dividend yields.

Materials (XLB)

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The material sector appears quite similar to the consumer staples sector as it was placed 7th out of 9 sectors in terms of year to date performance, yet has a fairly bullish momentum in terms of RSI (57.23). The MACD tells relatively the same story as the consumer staples sector as the MACD line has broken over the signal line and it is on the verge of climbing past the zero line which demonstrates a very bullish signal if it does not turn back. By looking at the MACD histogram momentum seems to be building as the spread between the short term exponential moving average and long term exponential moving average diverges even more. One of the main reasons for the shift in momentum in the material sector can be attributed to the surge in metal prices based on the demand anticipated through the rebuilding efforts in Japan.

Healthcare (XLV)

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The healthcare sector was placed 4th in terms of year to date performance and 4th in terms of RSI (56.74). The RSI much like most of the sectors is over 50 and shows some bullish momentum. The MACD line is also just breaking both the zero line and signal line which can be a very bullish signal. The bearish gap portrayed in the MACD histogram seems to have completely faded away and may be showing the beginning of a bullish momentum in the sector. Due to the earliness of this signal, traders would be urged to use stop orders as the predictiveness of the MACD and signal lines may at times provide a false indication and investors may get whipsawed. As well, the healthcare sector can also be seen as a "safe" sector where investors receive certainty on there investments and a decent yield. The strength in the sector can also be a play on the uncertainties in the world.

Industrials (XLI)

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The industrial sector is placed 5th in terms of RSI (56.52) and was placed second in terms of year to date performance. One of the sector's largest holding is General Electric (NYSE:GE), which suffered a large drop due to the Japanese nuclear reactor crisis, along with a few other stocks in the sector. Some of the rest of the industrials have been gaining, such as Caterpillar (NYSE:CAT), based rebuilding efforts in Japan. Much of the recent strength, shown by a crossing in the MACD line over the signal line and the zero line, is something investors should keep an eye on since the sector is due for a run back up due to the sector's recent pullback.

Consumer Discretionary (XLY)

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The consumer discretionary sector has been the third best performer year to date but is ranked sixth in terms of RSI (54.58). This RSI may be over 50, but just barely, and based on the RSI chart, it has recently been in a lower range showing weakening in the sector. The MACD seems to be loosing its bearish momentum as seen by the MACD histogram pulling towards a more bullish tone but it is still below the zero line and the MACD is just barely equal to the signal line. Therefore, I would be cautious entering this sector in the short term until a better signal is given. The sector's performance is lagging recently due to the anticipation that companies' margins will be squeezed due to higher material and commodity costs. As well, there are also worries that consumer purchases are slowing, which is not helping the sector.

Technology (XLK)

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The technology sector is in a very similar situation as the consumer discretionary sector since it is also correlated to material costs such as copper, as well as consumer discretionary spending. Both the RSI (52.31) and MACD are borderline bullish but very weak in momentum and strength. Although this sector did very well last year, its year to date performance sets it 5th out of the nine sectors, which demonstrates its recent weakness.

Utilities (XLU)

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The utilities sector has evidently taken the biggest hit in terms of the Japanese nuclear crisis, since many of the big nuclear energy providers are among this sector. The sector is the worst performer to date and is placed 8th based on RSI (48.70). The charts demonstrate the fear that investors had over nuclear energy as it drastically dropped down to oversold levels. Investors saw this opportunity and started buying back the sector bringing back up both the RSI and easing the bearish momentum shown by the MACD chart. Although the MACD has yet to confirm a buy, the MACD's histogram is demonstrating that the short term exponential moving average is slowly moving back to reach the longer term exponential moving average and I expect that once the nuclear fears ease the sector will return to run with a bullish momentum.

Financials (XLF)

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Lastly, the financial sector shows the worst RSI (48.43) and is placed 6th in terms of year to date performance. If investors recall, this sector was among the best performing sectors in the beginning of the bull market, yet this momentum seems to have faded as the American economy's growth slowly picks up. Many of the banks have had a very good run and have returned to profitable levels. The cyclical nature of bull markets shows that financials are usually among the best performers at the beginning of a bull market but then fade as they have already benefited from a strong run upwards. I do presume the financial sector will continue to creep up slowly in the long term as there is still value to be found. But it will definitely not rise at the same rate as before, since both RSI and MACD are not showing strong bullish signs for the sector.

Closing Thoughts

An interesting article on Best Stock Picks shows a chart by Investech Research that demonstrates the different stages of a bull market which interestingly coincides with some of the relative strengths portrayed in the sector charts.

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Based on the recent relative strengths, the financial sector, technology sector and the consumer discretionary sector all have weak momentum. The energy, consumer staples and materials sector appear as the top three sectors recently in terms of RSI, which coincides partially with the above chart. The reason some of the other sectors such as healthcare and consumer staples appear strong could very well be an effect of the uncertainty in the world and as we proceed later on to the end of the bull market, these sectors will gain more strength as investors shift out from "riskier" or more cyclical sectors to defensive sectors, which usually pay a healthy yield. The utilities sector will also join the group of defensive sectors but it recently sold off due to the Japanese nuclear crisis.

To all investors, I wish the best returns and encourage anyone with additional opinions on market sectors or any investment insight to comment below.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.