There is a major debate raging in the investment community right now. One that has been accentuated by the recent bout of volatility and weakness in the major averages, especially in the overowned areas of the market such as Technology and Communication Services. The debate centers on answering a key question: Is this the end of the growth trade? The answer to this question is simple…no one knows. I realize that this is not the cut and dry answer that most people want but the markets are anything but cut and dry.
Growth has been the undisputed champion for the better part of two years and for most of that time we have been correctly bullish on the theme. One look at the two year chart of the iShare Russell 3000 Growth ETF (IUSG) relative to the S&P 500 paints a very clear picture. The ratio is moving up and to the right above the rising 50 and 200-day moving averages. However, recently the growth stocks have faltered and the ratio has begun to hook down. Is this simply a case of an extended theme pulling back or is it the start of something else? Again, we have no idea.
For now, as a trend follower, I am content to defer to the trend and place higher odds on this being a pullback from an extended position rather than a reversal of the trend that has been in place for the better part of two years. But what if I am wrong? Are there areas of the market that are beginning to show signs of relative life that justify receiving some of our investment dollars? Let’s look at the different sectors of the market for some thoughts and ideas.
This chart shows us the performance of the sectors over the past year and we can see that the “growth” sectors, led by Technology have been the place to be. But does that mean they are the only place to be. Absolutely not. The simple fact is that this is not a binary decision. You don’t have to pick one and only one theme. It is perfectly fine to allocate a portion of capital to some of the cyclical areas of the equity market while also maintaining exposure to the growth leaders. In fact, I would argue that this makes a lot of sense. Why? Because in the event of a three day slide such as the one that we just witnessed, having 100% exposure to the theme that is getting hit the hardest is going to make the pain that much more severe.
Generally speaking, I view four sectors of the market as being cyclical in nature: Materials, Industrials, Financials and Energy. If we are going to begin to allocate a portion of the portfolio to the cyclical theme, does it make sense to own all four of these groups? I would answer that question in the negative. There is no reason to own an asset that is lagging simply for the purposes of diversification. The better course of action is to take the analysis a step further and identify which of these four sectors are beginning to prove that they are worthy of an allocation. A quick look at the three month performance of the sectors compared to the SPDR S&P 500 ETF (SPY) can begin to give us some clues. Over this time frame, the SPY is up by 8.57%. The favored growth sectors are continuing to outperform. But if we look at the cyclical sectors, we can see that only Materials (XLB) and Industrials (XLI) are performing better than the broader market.
Taking it a step further, we can see that, based on their Power Bar Ratios, these two groups have more stocks that are rated bullish in our 20-factor model than are rated bearish. So it makes sense to allocate to the two cyclical sectors that are actually performing better than the overall market rather than to all four of them.
The fact of the matter is that you don’t have to make an all or none bet. The market is much more nuanced than that. When I first started writing and talking about becoming more constructive on sectors such as Materials and more recently, Industrials, I received a lot of questions from people wondering if I had changed my tune on growth. That is certainly not the case, but I do recognize that other parts of the market are beginning to perk up. At the same time, not having all of my eggs in one basket serves to make the inevitable drawdown more tolerable when it arrives. The key is to make sure that you rotate into emerging strength and not into a sector or a theme just because it is “down so much.”
As an added bonus, your risk management process will tell you if you are on the right track and keep you in the trend for as long as possible. Is the process beginning to signal exits in one theme but not another? That is useful information that you should not ignore.