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We Didn’t Expect This Rally, But We’ll Take It

Look to risky sectors like tech for confirmation of the trend


Stocks continue to hit new highs while many investors scratch their heads. Do the fundamentals really support highs at this level or is this a technical rotation that has a lot of legs left? The evidence for the latter continues to build and last quarter’s amazing performance from defensive sectors may have set stocks up for new highs.

An Unexpected Upturn

Generally speaking, when defensive sectors are rotating into favor (like they did last quarter) the major market indexes will trend flat or slightly lower. That is what we would have expected in February through April of this year. However, performance among the defensive sectors was so strong that they were able to pull the market indexes higher despite the fact that the larger, and riskier groups were rotating out of favor and declining.

Over the last few years, this rotation has been cycling on a three to five month basis, which means that unless there is a larger disruption in the market, riskier sectors should be rotating into favor now. Because the tech, finance and materials sectors are larger than defensive groups, they can easily outpace the potential losses that may emerge among defensive sectors.

This is an unusual situation but not unheard of. In a situation like this we still want to look closely for confirmation because these “rotations without a correction” can be fragile. Something similar occurred in mid-2011 and a very small version of this also happened in the second quarter last year. In both of those most recent cases the expected correction did come – it was just much later than expected.

That isn’t a problem for short-term traders, but it does shift expectations a little. If the trend continues, then volatility will calm down and trades will last longer. Bullish opportunities should obviously be prioritized but some bearish anti-defensive trades could be used to mix in a little directional-diversification. As we work through the big Permanent Open Market Operations days in May, we will continue to look for confirmation of additional upside.


Click to Enlarge
The most significant confirmation we could look for right now would be to see risky sectors, like technology, definitively outperform defensive groups. We can look for this in two different ways. In the chart below you can see a graph of the SPDR Technology ETF (NYSE:XLK) that has yet to break the highs set during the last ‘risk on’ rotation in 2012. Getting above those price levels would be partial confirmation but not the most significant we could hope for.

In the chart at right we have also applied a relative strength comparison between the technology ETF and the SPDR Consumer Staples ETF (NYSE:XLP). The downtrend in the indicator since late last year means that defensive consumer staples stocks have been outperforming tech. We want to see tech break through the lows on the indicator around 0.80 to provide definitive confirmation that traders are looking for risk-on assets.

The reason a break above the indicator’s resistance level is important is that investors may still be anxious to flip back into a defensive stance in the near term if the market hits any bumps. If resistance holds, we don’t expect defensive sectors to be able to pull of the same gains they did last time. Breaking above resistance would indicate that investors aren’t interested in moving back into defense and it should accelerate the broader market trend.

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