Sector Rotation: How Energy and Consumer Staples May Reveal a Contraction

by: ChartProphet

Paying close attention to which sectors are outperforming other sectors or the overall market can tell us a lot about which phase of the economic cycle we are currently in – and where we may be heading.

As the economic recovery and expansion progresses, leadership within and among the various market sectors and industries can tell us a lot about how the economy is truly behaving. Depending on the relatively defensive or aggressive nature of investors at a specific time, the economic and business environment, and numerous other factors such as interest rates, forecasted growth, and the overall cause-and-effect nature of what has become a "global" marketplace, certain sectors outperform others at specific stages of the economic cycle. And the outperformance of certain sectors over others may actually be predictable!

Sector rotation is not a new concept. The idea that some companies do better than others in certain economic environments is well-established. For example, cyclical companies whose profits see-saw together with the strength or weakness of the economy perform much better during economic expansions that see a healthy, strong consumer with increased spending power to buy their products. At the same time, non-cyclical companies whose profits remain relatively unaffected by the ups and downs – due to the fact that their products are essential to consumers regardless of the economic environment – show much steadier performance throughout the economic cycle. Cyclical and non-cyclical are far from the only two sectors in the market (as financials, utilities, energy, basic materials, technology, and others exist as well); but the ability to monitor and compare the performance of the specific sectors and industries at various times may help us find future winners, improve asset allocation decisions, and even predict future market moves.

The rotation between the different market sectors is even predictable.

Take a look at the following chart:

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As you can see, different sectors outperform the others depending on the stage of the economic cycle. Based on the chart, the beginning of an economic recovery sees transportation and technology stocks outperforming others due to a pickup in economic activity, an increased need to physically deliver more products, and higher investment and expenditure on new technologies for the new business cycle. The cycle continues from early expansion to middle expansion and, finally, to late expansion – with different sectors dominating as the economy recovers, grows, and approaches an economic contraction. As the cycle then enters the contraction phases (early and late), other sectors stand to benefit. And the cycle repeats.

So if the performance of the various sectors reveals whether the economic recovery and expansion still has room to go, where in the cycle are we now?

Following a huge economic contraction and the onset of the Great Recession from late 2007 to early 2009, markets have rebounded tremendously – with the S&P 500 seeing returns of over 100 percent from the 2009 lows. But after nearly two years of historically record-breaking performance, many signs of potential trouble ahead are brewing. And according to the sector rotation theories we have discussed and presented, our current position within the economic cycle may be approaching the end of the expansionary phase.

Following the huge economic contraction of 2008 and early 2009, we can see that the Financial and Consumer Discretionary (Cyclicals) sectors led the way in early-to-mid 2009 as the economy was transitioning from late contraction to early expansion (note how these two sectors outperformed the others):

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Technology and Transportation have also led the way since mid-2010, as the economic expansion continued:

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But since November 2010, Energy and Basic Materials have outperformed the rest of the market, with Energy massively outperforming the other sectors by 6-11 percent:

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The massive outperformance of energy over the broader market over the past five to six months may serve as a very important warning signal of a potential end to the expansionary cycle in the economy. Due to rising energy prices and the buildup of increasing inflationary pressures, the energy sector usually outperforms at the end of the cycle. If the sector rotation theory is correct about the order of sector performance throughout the economic cycle, the onset of outperformance by the basic materials and energy sectors signals we have entered the late expansion phase and are nearing a contraction.

(Click to enlarge) (Murphy, Intermarket Analysis 200)

Actionable Investing Strategies

If the sector rotation is correct, then, we can expect consumer staples (NYSEARCA:XLP) and utilities (NYSEARCA:XLU) to outperform in the next phase of the cycle. In fact, if we see consumer staples and utilities outperforming, it may even be signaling the beginning of the contractionary phase in our economic cycle – and the potential beginnings of a new recession.

The first sign of a transition in sector strength, according to this theory, is the gradual weakening of the leading sectors and the strengthening of the next sector in line. In our case, the weakening of the energy sector in comparison to the consumer staples sector is our first sign of such a change.

From June 2010 until recently, energy and basic materials have far outperformed the consumer staples sector:

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However, since early March 2011, consumer staples have been outperforming both basic materials and energy:

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Such a shift in market leadership not only signals for a new investing strategy, but may also point to the beginnings of an economic contraction. Consumer staples stocks are generally safe stocks, and see heavy investor interest when economic downturns are on the horizon; since consumer staples companies [such as Procter & Gamble (NYSE:PG), Phillip Morris (NYSE:PM), Wal-Mart (NYSE:WMT), and Coca-Cola (NYSE:KO)] sell products that consumers must buy regardless of the economic condition, investors use these stocks as safe-havens and protection from the harmful effects that recessions have on most other companies. An increase in relative performance of the staples XLP in comparison to the other sectors, then, may be a signal that investors are beginning to decrease their risk exposure and that they may even be expecting a market downturn.

Our recommendation is therefore to invest in the consumer staples sector. Investors can do so by either investing in the broad consumer staples ETFs (XLP, RHS, KXI, FXG, VDC) or through individual companies within the sector such as Procter & Gamble (PG), Molson Coors (NYSE:TAP), General Mills (NYSE:GIS), Kraft (KFT), and CVS (NYSE:CVS) among others. The consumer staples not only offers relative protection in case of an economic downturn, but would also provide investors with income from dividends – as many consumer staples companies pay out dividends to shareholders. If our analysis is correct, the outperformance of the consumer staples over the next few months will not only provide a good investment opportunity, but may also signal the onset of an upcoming economic contraction.

Disclosure: I am long UNG, GAZ. I may initiate positions in XLP, PG, TAP, GIS