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Michael Michaud is the founder of Invest2Success.com (http://www.invest2success.com/) and the Invest2Success Blog (http://invest2success.blogspot.com/). He has been investing and trading in the financial markets since 1989. He founded Invest2Success.com to empower individual institutional... More
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  • This Tentative Bull Market & Cyclical Stocks  0 comments
    May 1, 2013 6:56 AM

    I Can't Believe It's Not Cyclicals! This Tentative Bull Market

    By Van Tharp Institute of Trading Mastery

    The best advertisers have a talent for making a phrase (one that is hopefully associated with their product or service) stick in our minds. For fun, let's see how well they've done. Please fill in the blank for these popular advertising catch phrases (extra credit if you get the associated product):

    "Melts in your mouth, not __ ____ ___"

    "Breakfast of _________"

    "Good to the Last ____"

    "Plop, Plop, Fizz, Fizz, - __ ____ _ ______ __ __"

    "I Can't Believe It's Not ______"

    Answers are at the bottom of the article (my apologies to those outside the U.S., though I'm sure there are advertising slogans in your country that are equally as memorable!).

    The last slogan I listed came to mind when I was doing some sector research recently. "I Can't Believe It's Not Butter" is (cleverly) both the margarine's brand name and catch phrase. The commercials for the butter substitute include various celebrities tasting the margarine and exclaiming incredulously-well, you know. (Obviously none of them were cooks…)

    While doing my routine stock scans over the last few weeks, I noticed with the same level of incredulity as those celebrity margarine tasters that traditional defensive stocks, indeed whole defensive sectors, were outperforming the usual stocks that lead the pack in up trends. Cyclical sectors that usually go gangbusters in bull markets like technology, industrials, financial and energy have been lagging considerably behind the staid old defensive sectors. Let's take a look at what is happening, dig into why, and then see if we can draw any sensible conclusions about where this could take us from here in terms of market direction.

    Could These Sectors Possibly Lead the Bull Market Charge?

    By definition, cyclical stocks and sectors are supposed to go up (or outperform) when the economy is strong and the stock market is in a bull phase. Counter-cyclical or defensive stocks and sectors are supposed to perform relatively better in down economic cycles and bear runs. Any analyst would see health care, utilities and consumer staples as classic defensive or counter-cyclical sectors. We can see the strong relative performance as expected with these defensive sectors in the last bear market from October 2007 to the low in March, 2009:

    (click to enlarge)

    This chart was made using stockcharts.com's Performance Charts and shows the performance of the various sectors RELATIVE to the S&P 500; all the sectors were down on an absolute basis during that period, but the top sectors in this chart show that they dropped less than the S&P or outperformed the index. And the leaders over that perilous time frame? Consumer staples, health care, and utilities.

    We would expect the opposite to take place in the big raging bulls - these defensive stocks should swoon while the cyclical sectors should dominate. Let's look at the two big rallies from the recent past - first, the grinding bull that followed the collapse of the internet bubble. This bull wound on from March of 2003 until October of 2007. The sectors' performances during that time frame (again, relative to the S&P) looked like this:

    (click to enlarge)

    Here, we can see that energy clearly led the pack, (although much of this outperformance was due to geopolitical tensions driving up crude prices) and materials followed. The laggards, as expected were health care and consumer staples.

    Now let's look at what happened from the March 2009 bottom up until the September 2012 intermediate top:

    (click to enlarge)

    This time, the consumer discretionary led the way (XLY, labeled as Cyclicals by stockcharts.com), Financials came in second with industrials and technology following strongly. The laggards in this up cycle were the usual suspects: utilities at the bottom, along with health care and consumer staples.

    This Year's Tentative Bull - The Cyclicality Turns Upside Down for a Few Months

    Since the beginning of 2013, we've entered the new, "post U.S. budget crisis" bull. While this bull has been persistent (the biggest pullback we've gotten since November of 2012 has been a mild 4.1% in the S&P), it has always had detractors that have expected a correction to come any day.

    I've called this the "tentative bull" because the traditional sectors are no longer leading the way; in fact, they're lagging. The defensive sectors are leading the charge, and by a wide margin. Here's the same performance chart set out from the beginning of 2013 to this last week:

    (click to enlarge)

    As we can see, health care has outperformed an already strong S&P by more than 10 percent! Consumer staples and utilities are not far behind. And all three of these far out distance the "also ran's" - consumer discretionary and financials, which outperformed the S&P by rather modest amounts.

    The flip side? Materials, technology, energy and industrials have all underperformed the S&P. What gives? This is incredibly non-traditional behavior for a strong bull market. And now for the final chart. I tried to quickly think of a few defensive individual stocks - the ones people turn to when times are bad. I thought of Walmart, Coca-Cola, McDonalds and Proctor & Gamble (maker of Tide and many other consumer staples) - four monster brands that tend to keep (or grow) their consumer base when times get tough. Here's the relative performance chart of those four companies and the S&P that you would not expect to see in a strong bull:

    (click to enlarge)

    This chart shows these defensive stocks outperforming the benchmark S&P index since the beginning of the year. Try to understand how unusual this is - three of these four stocks significantly underperformed the S&P during the bull run from March 2009 to September 2012 - McDonalds outperformed by a small amount. Similarly, the same three stocks (except McDonalds again) underperformed the S&P during the 2003 - 2007 bull run.

    So What Does All Of This Mean?

    When the defensive stocks lead the charge on a bull run and the "risk on" stocks under-perform, we might be getting a glimpse into the thought process of investors and traders.

    The best explanation that I have heard goes something like this:

    The market has had a strong run at the end of very long bull recovery. This up market has lasted more than four years. Despite the advanced age of this rally, money managers can't afford to get cautious and lag behind the benchmark S&P by only being partially invested.

    Since managers are concerned that the market is overdue for a correction, those who have to put new money to work are choosing defensive names so that their portfolios would take less of a hit when the pullback finally comes.

    All of this money going into defensive names is driving up traditionally weak bull market performers and attracting money into those stocks and sectors, driving their prices up even further.

    These factors have led to "risk on" or cyclical sectors underperformance. If the bulls can prolong the current up market, then money managers could once again become "true believers" in a longer-term bull and start rotating back into cyclical names - a move that could propel us even higher before that long-awaited correction comes. The Federal Reserve's ultra-loose monetary policy (combined with the same strategy at the Bank of Japan, the European Central Bank, etc.) has only added fuel to the fire. This excess stimulus will almost certainly lead to a serious market accident - but not until the market has trapped the maximum amount of money. That will probably take another new high (or three) to get every cent back into the equities game that's still on the sidelines for now.

    Current economic and corporate earnings numbers in the U.S. aren't helping much - they continue to be a mixed bag - some good news and some bad. Global equities markets continue to lag behind the aging bull in the U.S. (the notable exception being Japan). Emerging markets and China are especially weak. These dynamics will keep money managers driving with one foot on the gas pedal - they are trying to go as fast as they can, while the other foot is on the brake in anticipation of a sudden drop. As individual investors and traders, we need to keep alert for the signs of breakdown but we also need to remember that the U.S. indexes are still in grinding bull mode until further notice. If the 2003 - 2007 bull run taught us anything, it's that a free-spending Fed can keep the party going long after signs point to problems on the horizon.

    If you've found this article useful or thought provoking (or both), I'd love to hear your thoughts and feedback - just send an email to drbarton "at" vantharp.com.

    P.S. - For those of you who never bought that gazillion-inch flat screen, here are the answers to the product catch phrases and their associated product:

    "Melts in your mouth, not in your hand" (M&M candy)

    "Breakfast of Champions" (Wheaties cereal)

    "Good to the Last Drop" (Maxwell House coffee)

    "Plop, Plop, Fizz, Fizz - Oh What a Relief It Is" (Alka Seltzer effervescent tablets)

    "I Can't Believe It's Not Butter" (margarine)

    Click Here to Review the Van Tharp Institute Trading Education Home Study Programs and Training Workshops

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