Sector Rotation is Key to Market Action

Steve Kanaval  |

Portfolio Managers Battening Hatches

If you look at recent action in the stock market, you’ll see the merger of Kraft Foods Group Inc. ($KRFT) and Heinz has dominated the news cycle over the past few days.
But a closer look reveals selling in technology stocks, which have led most of the rally, and lends a large market clue to lower pricing when portfolio managers begin to shift sectors.

Often, the news cycle masks the real action in stocks. Sure, every news show talked about Kraft and Philadelphia Cream Cheese merging with Brazilian owned Heinz Ketsup, funded by Warren Buffet and Berkshire Hathaway Inc. Class A ($BRK.A), but a closer look shows a not so subtle move in technology, biotech and dividend stocks in general.

A look at the IBB index shows a sharp drop yesterday in the widely followed biotech index, and a closer look finds International Business Machines Corp. ($IBM) showing signs of technical topping. Also, large dividend stocks are getting large block selling pressure. There is also concern that upcoming Fed action will pressure markets lower.

When a portfolio manager rotates out of a sector, he goes to cash or another sector as he sees the economy shift, and most managers must stay invested according to their bylaws. Sector rotation is a big part of the strategy, and ironically, the internal models of many managers arrive at the same conclusions.

Many experts are looking for a weaker Q1 for 2015, and this could trip a slew of  pre-announcements from companies prior to reporting Q1 results. Managers have seen this in previous cycles when markets have had a prolonged bull run, and this bull has been longer than most, as many experts called for a top two years ago. Often, though, CFOs lowball upcoming quarters so they can outperform - they do this when they know they have something interesting in the pipeline. Early year underperformance is OK, but allowing your company to close out the year weak is bad for your job. 

Portfolio Manager Seeking the Lily Pad if Markets Turn Lower

When the tide goes out most stocks will go lower, and in today's ETF-dominated world, you can buy insurance that has 3x characteristics, meaning that you can buy a hyper Put and if the Dow goes down 100 points, you get 300 - so the tools are available for to you to remain invested, however, the ETF loses the same on the upside – it does not decay like an option. I see less and less use for these, because most managers are already hedged in some way, and if the markets get hammered, all you really need to do is get out of the market and get in cash.  But it is best to take money off the table in quieter markets, one of the weaknesses of managers is selling on the way down. This is difficult to do, and internal circuit breakers for percentage moves in the portfolio make this a reflex action, not a judgement call.

Think of sector rotation as a large ship turning in the harbor, and the crew running around tweaking things before it preps for a voyage - and the next time you watch a large ship moving slowly out of the channel, notice all the activity happening on deck as the crew battens down all lose ends. Sector rotation is essentially taking care of these loose ends, and this is exactly what smart portfolio managers are doing today when exiting Technology, Biotech and Dividend stocks in Q1 2015 in favor of a safe lily pad. You’ll likely notice how quickly that large ship moves out of sight and into the horizons of safe harbor…


DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:



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