Sector ETFs: The Market's Crystal Ball?

Includes: SPY, XLB, XLP, XLU, XLV
by: Michael A. Gayed, CFA

Almost universally looking for a correction during the past two months, investors were nevertheless caught off guard when it began in the last few days of February. This is because they were “lookin’ for danger in all the wrong places.” Thinking that Iraq, Iran, interest rates or inflation would be the destabilizing force, investors were kind of caught off balance when the “I’s didn’t have it.” Instead, the catalyst for the correction proved to be a combination of an over inflated China, an overly loquacious Alan Greenspan and an unwinding of the Yen-carry trade. All of which go to show that sometimes the catalyst can be a bit more provocative than the event itself.

Does this mean that the investment community is but a helpless bystander, whose very fate depends on how surprising current events turn out to be? We don’t think so, because experience suggests that the market has a unique way(s) of anticipating, or at least forewarning the possibility of important short-term trend changes in the broad averages.

One of those ways is the performance of various S&P sectors, whose trends often foreshadow the comings and goings of the S&P (NYSEARCA:SPY) itself. After all, the market rarely leads sectors. For example, the large Financials segment of the S&P500 often has the tendency of leading the market’s performance. This would seem to make sense given the importance the group has on the American economy. If financials do well in one period, it acts as a near-term signal that perhaps the equity markets may perform just as well in the next. On the other hand, certain other sectors may indicate a negative correlation with the market. The often touted inverse relationship between energy and materials prices and the broader market dictates that if oil and commodity prices, the inputs to products produced, perform well, then that might indicate a margin squeeze on producers which subsequently might result in inflationary pressure as those companies attempt to pass down their increased costs to the consumer.

The question now is what kinds of anticipatory signals were sectors generating prior to the May decline of 2006, and are there any parallels in the early parts of 2007? Sector performance indicates that there are a number of similarities. Since the middle of January 2007, the materials sector (NYSEARCA:XLB) has exhibited strong outperformance characteristics. The relative performance of materials to the broad market appears quite similar to its behavior in the days leading up to May 2006.

More so than that though, the Financials sector, which again is a fairly good signal of how the broader market may perform, is showing similar weakness to nearly a year ago. This time around, the catalyst for the Financials sector is the significant weakeness in the sub-prime credit market, which may reverberate to all other segments of the economy. Combine that with a pickup in the healthcare (NYSEARCA:XLV), utilities (NYSEARCA:XLU) and staples (NYSEARCA:XLP) sectors, all often cited as “defensive” sectors during a market decline, and which also started performing well in the weeks leading up to the May 2006 decline, and it would appear as though we’re in for a similar juncture in the coming months

There are some interesting differences to note however. While energy was the star in the early parts of 2006, they have not performed as well this year. Furthermore, the anticipated outperformance of the Technology sector this year, which has languished since their 2003 run-up, might mitigate a quick and severe decline this time around. Instead, we might see a grinding type of decline to follow in the coming months – with rotation out of the leaders of old and into the leaders of new, i.e. out of financials and materials, and into technology and healthcare. Instead of the market decline happening in May though, the sudden one-day turnaround in the markets in late February might serve as the early start to the potential grinding decline we could see this year.

What does the future hold, and what clues might signal an end to the ongoing and painful correction? The answer to the first part of the question is simple: we don’t know! Nobody has ever been able to consistently predict the exact design or pattern of any market trend. “How far and how long” make for nice media debates, but are virtually unknowable. But, not to worry. The market is always dropping little clues on our doorsteps, and by following the performance of various sectors, we can get a better picture of what the future might hold.

Disclosure: Author may have long or short positions in the groups noted but not necessarily in the ETFs mentioned.