Friday, July 10th, 2020

Rotation in the US

The period before the start of the Q2 results season in the US is often uneventful. Trading volumes have been higher than normal this year, but there have been no changes to our US sector ranking for two weeks and very few for the last two months. So, it may seem odd to argue that we are on the verge of a significant sector rotation, but that’s what we think.

There are three main reasons for this, all of which rely on data generated by our US equity sector model. First, the average weekly change in each sector’s weighting has fallen to a two-year low. The current rate of change is about half of what it was in June 2018 and 2019. This is unusually slow, even for a seasonally slow period. Second, the composite lead indicator for the whole index, is close to a 12-month high, having been well below its normal level from September 2019 to June 2020. This measures the amount by which the recommended weighting for each sector is expected to change (up or down) over the next four weeks. Thirdly, the level of conviction attached to this lead indicator has risen to a two-year high. This is measured by the goodness of fit (R-squared) between the trend-line (the lead indicator) and the underlying data.

In summary, the level of activity recommended by our model has been unusually low; the lead indicators predict significant change in the recommended sector weights and attach a high level of probability / conviction to this view.

For each sector there are two relevant pieces of information, the gradient of the trendline and the level of conviction. All sectors meet our definition of high conviction. The sectors with the most conviction are Materials, Consumer Discretionary and Communications, and those with the least are Healthcare, Financials and Industrials. However, all the conviction in the world counts for nothing, if the lead indicator is pointing sideways, rather than up or down. The sectors with the most powerful lead indicators are Energy and Materials (both positive) followed by Utilities and Consumer Staples (both negative). The sectors with the most sideways lead indicators are Technology and Consumer Discretionary.

The strongest combination of lead indicator and conviction level belongs to Energy. We have a very large underweight in the sector, but we expect to reduce this significantly. The next best combination belongs to Materials, where we expect the neutral position to be upgraded to overweight. The third and fourth positions belong to Utilities and Staples, where we expect to reduce our exposure. Utilities has already been downgraded to underweight and we expect Staples to follow soon. On the basis of these numbers, we do not expect much change to Financials or Industrials (both underweight) or to Technology and Consumer Discretionary (both overweight). The outlook for Healthcare and Communications is unclear, but Healthcare’s lead indicator has deteriorated badly in recent weeks.

Some may argue that it is premature to talk about sector rotation if we are not forecasting a change of leadership. We agree, but with two reservations. First, a change in laggards provides the same opportunity for generating alpha as a change in leaders. Second, these are just the signals we can identify now. Others may develop as we move into the results season. Rotations often start small and then get bigger as investors realise that their current positions are growing stale and that there is money to be made elsewhere.

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