Risk Rotation

Markets didn't do squat this week on the surface, under the surface however told a different story. Friday's in-line Jobs report wasn't enough to discourage interest rate hawks as TLT hardly budged following a nearly -3% loss earlier in the week. While the action in the SP500 has been choppy and unproductive, stocks have begun a rotation that appears to favor more risk appetite going forward.

What's the one thing that would surprise people the most? I think its a strong rally into the election and right on through. Nearly every person I talk to thinks the election will cause volatility, a big selloff, panic, etc. Those same people also think the market sits on the precipice of mortal disaster (and have thought that for years now).

The Friday release of the Non-Farm Payrolls for September showed the 79th consecutive month of US job growth. That means more people where hired in each of the last 79 months. I have heard it said that the market and job creation follow a very parallel path. Yet certain politicians tell us the US has never been in worse shape, well that's just simply not true. Things happened to be MUCH worse in 2008 than they are today. That's just a fact.

I determine relative strength/weakness by tracking the top 90 stocks in the SP500. Those top stocks showed a strong rotation this past week and have hinted this way for the last couple months. The typical defensive sectors (Utilities, Staples, REITs, Bonds, Metals) all got bludgeoned this week, while offensive groups (Financials, Technology, Energy, Discretionary) showed notable improvement in their underlying and relative trends.

So while the market churns above its prior all-time highs the correct stocks are seeing flows while it appears the over-crowded yield plays are rolling over. Now I am not of the opinion that dividend paying stocks will no longer have value, I still believe in lower interest rates for longer, but the absolute hoard of capital that has been hiding out in safety appears to be finding its way into higher risk/reward groups.

Can you spot the differences? (all charts Weekly)

Offense

Defense

Offense

Defense

Offense

Defense

As is the case with Relative Strength and Trend trading we want to be positioned toward the groups that are pointing up for our timeframe and avoid the groups pointing down.

Its certainly possible that these recent moves are just reverting to their longer-term averages and will be bargains again soon. But for now there are confirmed lower highs for Utilities, Bonds, Gold and I am seeing confirmed higher lows for Energy, Technology, and Financials.

Discretionary vs Staples

The Relative Performance of the Consumer Cyclical (Discretionary) vs the Consumer Staple stocks often suggests the risk appetite of investors in the market and general health of the economy. When consumers are spending more on discretionary items such as home improvement, vacations, toys, restaurants, etc it suggests the economy is healthy as people have extra money to spend, and this ratio rises. If by contrast people are simply getting the essentials like toilet paper, toothbrushes, and cleaning products instead of booking trips to Hawaii or buying new tvs on Amazon, this ratio will fall.

 As of last week we are seeing the first relative uptrend emerging for the higher risk Discretionary sector relative to its more defensive counterpart since late 2015.

I know it almost "seems" too easy, but had you simply taken these signals and the previous two going back to the inception of the XLY and XLP funds, you would have outperformed the SP500 by more than 250%. Just buying the SP500 when this ratio breaks a downtrend and raising cash once the uptrend invalidates would have crushed the return of buy/hold since 2002.

If we are putting money to work we want to look for setups coming out of the relatively strong sectors at the right cycle points for the market as a whole. It appears we have a new cycle buy signal in our ratio above.

 At the close of September (9/30/16) the XLY:XLP ratio has moved above its relative downtrend and is pointing higher. If the past 15-years has been any guide this is not a signal to ignore. With the SP500 still holding above its prior highs and pulling back orderly to retest the July breakout, it appears the path of least resistance is higher.

Yes I know there is the biggest presidential election of our lifetime looming, yes I know US debt is "too unsustainable", and yes I know the Federal Reserve is suppose to raise interest rates like yesterday. The fact remains stocks and sectors under the surface are showing rotation that is indicative of more upside to come.

I mean the Nasdaq is at ALL-TIME HIGHS, yes even above the dot.com bubble peak.

This is not bearish. Above this line there is zero justification to being Short or in cash. Its bombs-away as far as I'm concerned.

Don't hate me, I'm just the messenger.

Thanks for reading
-ZT