Sector Rotation Can Keep the Market Afloat - and This Group Looks the Best Now

If there are two major things we learned during the epic, 70%-plus crash in oil prices between 2014 and 2016, it’s that …

1. The market as a whole can continue on its merry way even when an individual sector faces major, bankruptcy-inducing headwinds. Indeed, outside of oil/gas and a few energy-dependent materials and industrial names, the averages continued to rise because the relative weights of those energy-dependent sectors were lower. Strength elsewhere in consumer, transportation, and technology stocks offset that weakness.

2. Our Weiss Ratings model can do a great job of keeping you out of lousy stocks in tumbling sectors. As oil tanked, we gave speculative oil and gas miners poor ratings for high indebtedness, high capital expenditure, and negative cash flow and earnings.

But what about today? What else did we learn about sector rotation then that we can apply to the current market now?

First, our market’s resilience stems from the robustness of our economy. Countries that rely heavily on one sector or commodity can get crushed by things like the downturn in oil. But we are much more diversified, and have many more sectors that contribute to our economy.

Second, that diversification is reflected in the current breakdown of the S&P 500. The pie chart below shows the index weightings by sector. You can see that diversified industries like technology, healthcare, financials, consumer discretionary, and consumer staples all represent sizable chunks of the market.

Third, over the years as select sectors outperform and their market capitalizations increase, their weights increase. That means sector reliance becomes more important to investors.

That’s what happened with tech. It was only 18% of the S&P in 2013, while energy was 10%. But thanks to outperformance in tech and the crash in energy, those weightings have changed to 23% and 6% respectively.

So which sectors are leading the way now – and which do I think should continue to do so? Well, healthcare is in limbo due to the raging political discourse about insurance coverage and costs. That’s why I’m zeroing in on tech and financials. They have become so large, the rest of the market can’t help but take notice. Our rally now hinges on one or both of these sectors doing well.

The good news there is that they show few signs of letting up. Take a look at this chart showing their post-election performance:

Right after the elections, tech only managed small gains while financials ripped higher amid hopes of accelerating growth and bank deregulation. But tech has since caught up, and they’re both now at the same exact point gains-wise.

As for the future, I use our Ratings Model for guidance. That’s because following the numbers allows me to avoid biases, emotions, and subjectivity.

Specifically, I analyzed the percentage of BUYs versus SELLs per sector, then took the second derivative to assess the change in those ratios. The idea was to identify which of those sectors was seeing more stocks being upgraded versus stocks being downgraded.

The winner was … Financials! As you can see in this chart, the financials have seen a stronger and more consistent improvement in ratings than tech stocks:

Bottom line: Sector rotation can keep the overall market rally going, particularly when the largest sectors are leading the way. So watch tech and financials to gauge its health. And out of the two, our Weiss Ratings model points to financials as the soundest place for your money going forward.

Best,

Mandeep

Small Cap Edition, By Mandeep Rai, Senior Analyst Mandeep Rai has more than 15 years of investing experience, working as both a stock and credit analyst. At Weiss Ratings, he researches and evaluates financial and economic themes, and makes decisions on when to buy or sell specific shares for the Top Stocks Under $10 portfolio.