Inside the Toolbox: Monitoring Sector Performance

We thought it might be insightful this month to share with you one of the tools we use in analyzing sectors and sector performance.

It is always useful to have simple ways to keep market moves in perspective, and one way that we do this is by looking at the relative performance of the 11 major market sectors, over both long-term and short-term time frames.  By doing this, we gain insight into the “internals” of the market, including where money is currently flowing.  From this, we can determine whether we are in a “risk-on” environment (when investors are shifting from more conservative to more aggressive segments of the market), a “risk-off” environment, or an environment of digestion, during which sector rotation often occurs.

These 11 sectors are segments of the S&P 500, which itself is composed of large-cap U.S. stocks, the sectors’ moves are often highly correlated.  As such, looking at just the price movement can be fairly “noisy” (difficult to see the forest for the trees).  The signal and insights, therefore, lie in the movement of a sector relative to the index itself.  We can look at this by charting the ratio of sector prices, rather than a sector price alone.  For example, to chart the relative performance of tech stocks (XLK) vs. the S&P 500 (SPY), we take the dividend-adjusted price data for XLK and divide that by SPY, or XLK/SPY.

We then watch these ratio charts for trends, over both long- and short-term time frames, for each market sector.

Long-term – 15-20 years

What we’re looking for in these long-term charts are consistent trends.  Uptrends, which mean the sectors have a solid history of outperforming the S&P 500 as a whole, are preferred and looked at for investment.  Downtrends offer insights into the segments of the economy that are either struggling currently or the market believes will struggle in the future. These sectors are generally to be avoided. Look, for example, at two sectors on the left side—Technology and Consumer Discretionary.  Both have years of relative outperformance.  On the other hand, look at the Materials and Energy sectors, which have long been underperforming the S&P 500.

Short-term – 10 months

Again, what we want to see are uptrends, especially when there appears to have been a reversal, such as Health Care (on the top right).  On the other hand, Energy has consistently underperformed.  Short-term charts are also useful in identifying turning points. Note that real-estate in particular which attempted to “break-out” relative to the S&P 500 after months of equivalent performance only to reverse. It is no coincidence that this occurs near a long-term resistance point as well.

Charts created by Viridian, in TradeStation, using FastTrack data.

While these charts alone are not the sole basis for deciding which sectors to buy or sell, they are a good tool for evaluating relative strength and weakness, and aid or confirm our decisions to buy, hold or sell given market sectors.

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