We’re in the last few weeks of the first quarter and in the investment industry that means a lot of smart people are going to be doing something that seems very silly to others, studying charts and performance data either in an attempt to explain why everything that happened in the market made sense or to forecast what’s coming next. That may sound like a lot of bunk to some people, but what are those heat-maps and Callan tables in chart packs but colorful descriptions of past performance? Sector rotation is particularly vulnerable to this, I mean haven’t we all said something like “wow, xyz sector has really underperformed over the last 3 years, it must be due for a comeback!”
Yes, the sad truth is that these sorts of “techniques” have been used by investment professionals for years and aren’t going away anytime soon, but consider that a blessing, not a curse. No one is going to argue that you can’t get a lot of valuable insight from studying sector funds but being smarter about how you analyze the markets gives you an edge, and in this case, knowing exactly what kind of sector fund you’re working with or else you can draw some dangerous conclusions.
A Simple Experiment:
To prove that, we decided to run an experiment by comparing charts for two different sectors that have seen some of their biggest names in the news recently. First is the industrial sector where The Boeing Company (BA) is facing an existential crisis over its ubiquitous 737 jet that has shaved tens of billions off its market cap. The other is the technology sector where behemoths like Amazon (AMZN) and Apple (AAPL) have seen their stock prices surge despite facing their own crisis over populist fury.
Our “experiment” is to compare short-term daily charts from two funds in each sector to see how they compare, and what lessons we can learn about chart analysis with sector funds while we’re at it. To make this as much an “apples-to-apples” comparison as we can, we’ll use funds that draw their holdings from the same universe, the S&P 500. We’ll start with the largest and most-well known sector funds, State Street’s (NYSE:STT) SPDR series which like the S&P or Vanguard’s universe of sector funds are weighted by market cap. Then we’ll compare them with their equally-weighted competitors from Invesco. That should reduce the role of those mega-cap names at the top of the S&P and gives us some idea of just how much broad support this rally enjoys from the smaller names in the market.
It can be hard to spot the difference between our two industrial sector funds, although given how staid and relatively small the space is, that’s hardly surprising. The first chart is the common “go-to” for most investors, the Industrial Select Sector SPDR Fund (XLI) which like most SPDR sector funds has a substantial part of its portfolio in the top ten names, although at 46% this is well below that of the more popular sectors. Obviously, Boeing is going to be at the top of that holdings report at 8.75% and with its stock down over 10.5% last week, investors can be forgiven for expecting a miserable chart of XLI although the reality is that it isn’t as bad as you might think.
You can see that March hasn’t been kind to XLI with the ETF now stuck below its 20-day moving average (DMA) after having found support at prior resistance close to $73 and just above the 200 DMA at $72.34. That might be enough for investors to damn the entire sector, but if XLI is heavily weighted towards larger names despite having 79 holdings in all, what kind of picture might emerge if we compare it with an equally-weighted with the exact same holdings?
Fortunately, the Invesco S&P 500 Equal Weight Industrial ETF (RGI) perfectly fits that bill and despite its similar stories, RGI seems to be telling a different story.
No, you’re not seeing double although only the ticker and share prices might seem different. Both ETFs had strong winter rallies that foundered for a short period around their 200 DMAs and both were trapped under their 20 DMA although RGI just broke above it! There are still some minor differences. RGI came much close to breaking below its 200 DMA but found support at the old December high and just broke above 20 DMA thanks to a strong showing by smaller names. Meanwhile, XLI looks like it could soon see the 50 DMA crossing the 200 DMA from below, typically a bullish signal, RGI’s 50 DMA is a lot further from the 200.
So why the similar charts, almost identical in fact, charts? Partly because they do hold the same stocks although a chart of the much broader, Vanguard Industrials ETF (VIS) is almost identical to the first two. What’s the trick? In this case, it has more to do with the sector than the fund. The industrial space isn’t exactly bursting at the seams with new companies joining the fold while the differences in the allocation between RGI and XLI are relatively small. RGI weights each position equally when the fund is rebalanced and as of 3.15, the weights range from 1.87% GE (GE) to 1.19% Alaska Air (ALK). And XLI might weight by market cap, but only 15 of its 79 positions are in excess of 2%, so the allocation effect of a strong performer between the two funds is relatively muted.
Ultimately, these charts might not be sending out an easy-to-discern buy signal, the fact that both funds have found support and aren’t plumbing new lows despite the presence of Boeing in their portfolios is a positive sign. What those similar charts also tell us is that despite the different weights, the performance across the stocks in the sector is likely to be highly comparable. In fact, whether you look at the YTD, 1, 3, 5- or 10-year trailing performance, RGI and XLI have almost identical returns while VIS is typically within 30 to 50 bps of them. One fund might outperform the others in one year thanks to a particular name, but in the long run, they tend to average out and so XLI or RGI can serve as an equally good sector proxy.
You get a somewhat different story when you shift to the technology sector whose influence (and membership) in the S&P 500 expanded to the point where a large chunk had to be carved out and shuffled off to the new Communication Services sector. In fact, only 2 of the top 10 S&P 500 components are still technology stocks, including Microsoft (MSFT) and Apple, a frequent target of Elizabeth Warren and other populist critics who argue for anything from fines and penalties to its dismemberment.
From a fund standpoint, that concentration at the top of the S&P 500 means that MSFT and AAPL are even more concentrated in a market-cap-weighted fund like the Technology Select Sector SPDR Fund (XLK) where just those two stocks make up over 34% of the fund with the other top 8 adding another 30%. That doesn’t leave a lot of room for the other 89 holdings, so we would expect to see a slightly different chart when comparing XLK to its equally weighted equivalent, Invesco S&P 500 Equal Weight Technology ETF (RYT). In fact, from 2009 to 2013, the performance gap between the two was often in the double-digits although the degree of under/out performance has dropped noticeably in the last five years.
First, as you can see in the chart below, XLK wasted no time in recovering most of its 4Q losses, with just a brief pause at the beginning in March when the fund retreated to prior support close to its 200 DMA. An impressive showing no doubt, although a contrarian would point out that the Relative Strength Index score (a favorite tool of the Dorsey Wright crowd) is in overbought territory while the Chaikin Money Flow value has been weakening since February.
That would seem to indicate that mega-cap technology names have recovered a lot of lost ground although are still below their October peaks and could be overdue to take a breather, but what about the more large and mid-cap focused Invesco S&P 500 Equal Weight Technology ETF?
Here you can see a similar although ultimately very different story. Not only did RYT already push its way back to the old October highs, but it did it in a much more rapid fashion than XLK, achieving this milestone largely by the end of February. And like its market-cap-weighted brother, RYT struggled at the start of March and while it has regained those losses, it in fact hasn’t gotten much further than that, although all that early success means its 50 DMA looks set to cross the 200 DMA anytime now although the already high RSI and overhead resistance make you wonder if a multiple top might be forming?
What can that tell us? That investors love “smaller” tech stocks is obvious! Remember that RYT and XLK have the same stocks, but different weights, with many of this year’s stronger performers coming from the smaller names like Xerox (NYSE:XRX) or Cadence Design (NASDAQ:CDNS) with no clear preference for value or growth. In fact, if you bought RYT at the market peak, you’ve already recovered your losses, something neither XLK and certainly not XLI can boost.
But all love affairs come to an end and while RYT was quick to regain its prior losses, it has struggled to advance to new highs, underperforming XLK over the last month. That could signal that investors need a cooling-off period, but it could also mean that the action is shifting to MSFT and AAPL. Whether that’s because of their own merits, or simply because they’re simply catching up to the rest of the sector remains to be seen.
Obviously studying charts is just part of the story, fundamental investors would be driven more by earnings reports while all investors should be worried about the increasing political pressure that mega-cap tech names are facing. But with most S&P 500 technology stocks back to their old highs, and hopefully a trade deal with China coming soon, markets shouldn’t be surprised if investors begin to favor other sectors instead!
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.
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