The S&P 500 (NYSEARCA:SPY) has moved substantially higher since the February retest of the January 2016 and 2015 lows. Despite the rapid advance in market valuations there are still opportunities to maximize portfolios by moving capital from underperforming sectors into sectors that are leading. Below, you will find a description of how and why it is important to quantify market risk, recent sector leadership changes which include actionable ideas for some investors, and a brief explanation of how the favored sectors are determined.
There is no new thing under the sun (Ecc 1:9)
The headlines in the news change daily and market leaders change regularly but, the one thing that remains consistent over time is how humans react to stock market volatility (aka fear and greed). No matter how many times a fire drill is rehearsed, when an emergency presents itself, the exit is often not pleasant. Likewise, during highly volatile markets and market inflection points, human emotion is a consistent and measurable phenomenon that generally isn't accounted for in any research report or stock analysis. This observation led me to create a method for quantifying these human emotions and consequent reactions to short term market activity. Regardless of education, wealth, knowledge, or any other factor that may make a person seem wise, people react the same way when fear or greed sets in.
This methodology is by no means perfect however, it is a best effort attempt to quantify the belief that many things will return to some sort of mean over time and that people consistently exhibit the same undulating responses to fear and greed. Consequently, it is possible to view the ebbs and flows of the markets as ocean tides. When the tide comes in, risk is higher and conversely, when the tide flows out, risk is lower. Although it is not possible to consistently predict exactly when a correction or bounce will occur, it is possible to examine whether the tide has come in further than normal, presenting greater risk or gone out further than normal, which is part of the requirement for identifying a "lower-risk entry point". A sophisticated investor can often determine when there is more or less inherent risk in the market and when a trend is changing.
When risk is elevated, active investors should begin trimming losers, laggards, and potentially take partial gains from winners in portfolios. Investors may also consider reviewing the types of positions worth holding when things get ugly. Long-term asset allocation investors can look at re-balancing portfolios by shifting equity gains to other asset classes that are less correlated to the market. Some investors may also consider hedging strategies like selling calls, purchasing puts, or stop limit orders to try to mitigate risk.
Conversely, when risk is lower, a plan of action should be in place with a buy list of favored mutual funds, equities, and ETFs already having been identified. Secondly, it is essential to identify a high volume, high volatility, downside trading day that is coupled with a strong reversal and 1-2 days' follow through. When all of these conditions are met, this methodology will then recommend the purchase of equities.
Recent sector leadership changes
- Emerging markets (NYSEARCA:EEM) moved into favor on 03/17/2016 (NA)
- The basic materials sector (NYSEARCA:XLB) has moved into favor as of 03/11/2016 (XLB 2.23% vs SPY +.92%)
- The Dow Jones Transportation Average (BATS:IYT) turned positive on 02/12/2016 (IYT +13.18% vs SPY +9.64%)
- The energy sector (NYSEARCA:XLE) turned positive on 1/29/2016 (XLE +9.54% vs SPY +5.63%)
- Financials (NYSEARCA:XLF) moved out of favor as of 1/29/2016. (XLF +4.19% vs SPY +5.63%)
Note: Parentheses indicate gain or loss, excluding dividends, between trend change date and 3/17/2016.
Leading sectors as of 03/11/2016
Basic Materials: The materials sector has moved into favor due to near term relative strength versus the S&P 500. Materials exhibiting relative strength versus their sector include:
- The Sherwin-Williams Company (NYSE:SHW)
- E. I. du Pont de Nemours and Company (DD)
- Alcoa Inc. (NYSE:AA)
- AK Steel Holding Corporation (NYSE:AKS)
- United States Steel Corp. (NYSE:X)
- Newmont Mining Corporation (NYSE:NEM)
- The Scotts Miracle-Gro Company (NYSE:SMG)
- Bemis Company, Inc. (NYSE:BMS)
- Air Products and Chemicals, Inc. (NYSE:APD)
- Airgas, Inc. (ARG)
- Albemarle Corporation (NYSE:ALB)
- The Dow Chemical Company (DOW)
- AptarGroup, Inc. (NYSE:ATR)
- Celanese Corporation (NYSE:CE)
- Ball Corporation (NYSE:BLL)
- Avery Dennison Corporation (NYSE:AVY)
- Vulcan Materials Company (NYSE:VMC)
- Sonoco Products Co. (NYSE:SON)
Dow Jones Transportation Average: The transportation sector has recently turned positive on 02/19/2016. A partial list of equities in the transportation sector include, United Parcel Service, Inc. (NYSE:UPS), Swift Transportation Company (SWFT), and Union Pacific Corporation (NYSE:UNP), Latam Airlines Group S.A. (LFL)
Energy: The energy sector recently turned positive on 01/29/2016 and a partial list of energy sector components include, NRG Energy, Inc. (NYSE:NRG), Schlumberger Limited (NYSE:SLB), Exxon Mobil Corporation (NYSE:XOM), Halliburton Company (NYSE:HAL), Concho Resources, Inc. (NYSE:CXO) are trading positively when compared to the S&P 500 index.
Industrials: The industrial sector (NYSEARCA:XLI) and some of the leading components include, General Electric Company (NYSE:GE), 3M Company (NYSE:MMM), Honeywell International Inc. (NYSE:HON), Lockheed Martin Corporation (NYSE:LMT) are continuing to trade positively.
Consumer Discretionary: The consumer discretionary sector (NYSEARCA:XLY) and a partial list of consumer discretionary components include, Scripps Networks Interactive, Inc. (NYSE:SNI), The Home Depot, Inc. (NYSE:HD), Time Warner Inc. (NYSE:TWX), Comcast Corporation (NASDAQ:CMCSA), McDonald's Corp. (NYSE:MCD), Starbucks Corporation (NASDAQ:SBUX), NIKE, Inc. (NYSE:NKE) are continuing to move positively on relative strength.
Consumer Staples: The consumer staples sector (NYSEARCA:XLP) and a few selected components have been pretty solid. The following ideas are showing leadership within the sector: The Procter & Gamble Company (NYSE:PG), The Coca-Cola Company (NYSE:KO), Altria Group Inc. (NYSE:MO), Wal-Mart Stores Inc. (NYSE:WMT), Cencosud S.A. (NYSE:CNCO)
Technology: The technology sector (NYSEARCA:XLK) is still in favor and a partial list of technology components include, Agilent Technologies Inc. (NYSE:A), Alphabet Inc. (NASDAQ:GOOG), SanDisk Corp. (SNDK), Microsoft Corporation (NASDAQ:MSFT), Facebook, Inc. (NASDAQ:FB), Automatic Data Processing, Inc. (NASDAQ:ADP), Nuance Communications, Inc. (NASDAQ:NUAN), Edwards Lifesciences Corp. (NYSE:EW), Cisco Systems, Inc. (NASDAQ:CSCO)
Utilities: The utilities sector (NYSEARCA:XLU) continues to be in favored status and Duke Energy Corporation (NYSE:DUK), American Electric Power Co., Inc. (NYSE:AEP), Southern Company (NYSE:SO), Dominion Resources, Inc. (NYSE:D), PG&E Corporation (NYSE:PCG), Public Service Enterprise Group Inc. (NYSE:PEG), are some of the utility sector components.
Transitioning sectors close to becoming favorable:
Financials: The Financial Sector moved out of favor on 01/29/2016 based on relative strength. Despite being in a sector that's out of favor, financial sector components that are moving positively include, The Allstate Corporation (NYSE:ALL), Banco de Chile (NYSE:BCH), Brown & Brown Inc. (NYSE:BRO), CME Group Inc. (NASDAQ:CME), Nasdaq, Inc. (NASDAQ:NDAQ), Oaktree Capital Group, LLC (NYSE:OAK)
Healthcare: The Healthcare sector (NYSEARCA:XLV) is out of favor but, the healthcare sector has some components that are moving positively on relative strength, Bristol-Myers Squibb Company (NYSE:BMY), Mylan N.V. (NASDAQ:MYL), Johnson & Johnson (NYSE:JNJ), ResMed Inc. (NYSE:RMD), and Stryker Corporation (NYSE:SYK)
The MSCI EAFE (NYSEARCA:EFA) is currently out of favor. Some areas that are showing relative strength are Chile (BATS:ECH) or (NYSEMKT:CH), Latin America (NYSEARCA:ILF), Brazil (NYSEARCA:EWZ) and Emerging Markets EEM.
The equally weighted S&P 500 (NYSEARCA:RSP) or Invesco's Equally Weighted S&P 500 fund (MUTF:VADAX) is a different approach to owning the S&P 500 index. Rather than own an index where the largest market capitalization stocks have the most effect on the index, the equally weighted S&P 500 holds an equal amount of each component of the S&P 500 index. The equally weighted S&P 500 is also positive against the S&P 500.
Methodology for determining favored sectors:
Christopher G. DeMaria has over 18 years of experience managing money for individuals, corporations, and foundations. While adapting from successes and failures throughout some of the most challenging markets since the Great Depression (1998 to 2016), his methodology has been continuously tested over that time in order to improve its reliability and effectiveness.
Part of his investment methodology includes a quantitative approach to identifying changes in trends at early stages and continually monitoring their relative performance against one-another. This process uses simple mathematical ratios (i.e: SPY /EFA or SPY/XLB) to determine when one asset class is performing better than another. When properly calibrated, these ratios can provide a precise moment when the trend in one asset changes compared to another.
This process is most effective when portfolio holdings are methodically adjusted based on different levels of market risk and relative asset class performance. As stated above, when risk is higher, portfolio holdings should be reallocated out of lagging or losing asset classes and moved into leading, lower risk, or non-market correlated assets. This process inherently frees up cash for future "lower risk entry points" when assets can be allocated back into equities and other favored assets. Essentially this is a systematic approach designed to attempt to purchase leading asset classes when market risk is lower and sell lagging and losing positions when market risk is higher. In the end, the goal is to buy low and sell high.
There are three key factors to successfully implementing this portfolio management process. The first is having sufficient knowledge and understanding of the financial markets which takes time to acquire. The second is having adequate time and dedication to develop skill. The third is having the proper discipline to continually monitor the process. Many individuals have some or even all of these characteristics but, simply lack the time, interest, or expertise to dedicate themselves to managing their own portfolios properly. With the exception of those whom are confident in their knowledge, skill, and discipline to manage this process, it is strongly advised to seek professional assistance.
The lows still appear to be holding despite the doomsday predictions from many Wall Street pundits. Over the ensuing months, it is important for both the Dow Jones Industrial Average (NYSEARCA:DIA) and the Dow Jones Transportation Average to move on to new highs in order to eliminate any doubt about a possible Dow Theory Sell Signal. New leadership has been emerging from the energy, transportation, materials and emerging markets with indications that small caps, and midcaps, are very close to turning positive. These new leading sectors can provide many opportunities to enhance portfolio returns as the market appears to have a more broadly based recovery than what was experienced off the 2015 lows. Finally, we still appear to be in a long term secular bull market that began in 2012 and until that trend changes, pullbacks may be viewed as buying opportunities.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Additional disclosure: The information contained in this report or information provided does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered reliable, but we do not guarantee that the foregoing material is accurate or complete. Expressions of opinion are as of this date and are subject to change without notice. This information is not intended as a solicitation of an offer to buy or sell any security referred herein. Past performance may not be indicative of future result. No buy or sell orders may be given using the email, please call the above number to contact your Advisor. Christopher DeMaria is registered with and securities offered through Kovack Securities, Inc. Member FINRA/SIPC. 6451 N. Federal Highway, Ste 1201, Fort Lauderdale, FL 33308. Investment Advisory services are offered through Kovack Advisors, Inc. DeMaria Financial Services 865-332-5952 is not affiliated with Kovack Securities, Inc. or Kovack Advisors, Inc. Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.