Rotate from Energy into Financials

Despite the gloom and doom espoused by many economists, the current stock market recovery has been extraordinary only in how normally it has progressed. 

One of the mental models I use to try and get my bearings in the market is the sector rotation concept created by Sam Stovall.  Stockcharts.com provides an excellent area to track the progression of market sectors. 

Starting in 2003, the sectors have followed the rotation set out by the rotation chart almost to a tee. I’ve broken the market into 3 to 4 month segments since 2003.  In the dark days of 2002, everything went down so it’s not really worth analyzing.

However, in the five months of 2003, prior to the Iraq War, the market started the bottoming process.  Financial stocks and consumer discretionary stocks started to outperform the S&P 500. 

As the rally in 2003 heated up, Technology and Industrial stocks started outperforming.   This was classic early economic cycle behavior. 

And directly according to the script, the Material and Energy stocks started outperforming toward the end of 2003. 

The market digested the strong gains of 2003 during 2004.   The market had already discounted the strong economic recovery as seen by the outperformance of energy stocks.  In addition, investors were beginning to rotate into more defensive sectors such as Consumer Staples and Health Care, betting on the beginnings of an economic slowdown.

However, the healthcare stocks soon caved under the drug stock problems.   Other health care companies such as HMOs did fine but the drug stocks like MRK became a drag.  I think the drug stock bust "scattered" money into several other sectors.  Both defensive utility stocks and cyclical industrial stocks did well, which you wouldn’t typically expect to happen.  This was one quarter where the sector performance model did not look "normal."

As 2004 came to a close, the market began a strong run, lead by Technology and Consumer Discretionary stocks.  Investors were beginning to bet on a new round of economic growth…that is until Energy started out performing everything else.  Now only defensive Utility stocks are keeping pace with the Energy sector, which has depressed every other sector since September 2004.   The black bar of Energy looms very large over the rest of the market.

The question becomes, what happens next?  According to the economic sector rotation model, financials should start groping for a bottom.  This makes "Stock Market Sense."  The Financial sector has been hit because of rising interest rates and a flatter yield curve.  Rates have been rising because of the Fed, which is fighting inflation of higher energy prices.  If energy and the Fed combine to slow the economy, then rates will come back down – which in turn would be good for financials. 

The one flaw in this argument is the potential of external problems in the financial sector from the likes of AIG, FNM, or FRE.   These stocks have been weighing on the financials as much as higher rates.  However, if they find their footing, then I would expect the financial sector to become very attractive in the upcoming quarter.