What is the physics of a market bubble? In my previous article, I wrote about the phases of market bubbles, which generated a lot of buzz, specifically after the volatility debacle of early February. You might recall from that article that I discussed the recipe for a “melt-up” in a bubble economy. The “melt-up” phase is the near parabolic move of a market signifying the near-term top of a market bubble. One of the drivers to consider when assessing the phases of the market bubble is the correlation with sector rotation.
For those unfamiliar with sector rotation, it is the flow of money of top-performing sectors of the S&P 500 from one to another overtime. The S&P 500 is broken down into sectors like technology, financials, industrials, and so on, but not all sectors are behave the same at the same time. This is referred to as the sector rotation model. The sector rotation model can be broken down into three types of investment profiles. For simplicity, let’s call these growth, protection, and defensive. The sectors that are most active during a growth phase are typically the financial sector, the technology sector, and the consumer discretionary sector. When we see these sectors as the leaders of overall market performance for a given period of time, it historically signifies continued market growth and a bull market.
As investors pile on and those sectors become overvalued, smart money looks for other sectors that have not performed as well and are value positions. These are typically industrials, basic materials, and energy. Historically, when energy is the top-performing sector it signals that we are at or near peaks in a market, and typically basic materials are laggards in early growth but excel in late bull markets. Finally, when the market begins to decline oftentimes investors are looking for defensive positions, and the sectors that are most attractive are utilities, consumer staples, and healthcare. The justification for this move appeals to common sense as people don’t stop going to grocery stores, using electricity, or stop taking their medication, for instance, in a bear (down) market.
So what does this have to do with the current economic and market landscape? Over the last quarter and even over the last year, though energy is still not our top performing sector, we have seen explosive growth in the fundamental driver of energy which is oil. As oil has rallied from $26 a barrel to over $60 a barrel, there is a potential for oil stocks like Exxon Mobil (XOM), Chevron (CVX), and many others to rally as well with “fair price areas” far above current price. These are major components of the energy sector. We have also recently seen stocks like US Steel (X) with tremendous gains after lagging in the bull market run of the past few years. This combination of energy, basic materials, and industrial stocks surging is very typical of late bull market movements.
Over the coming months and into the summer season, an investor would be wise to pay close attention to these sectors, and if we see that energy, industrials, and basic materials transition into sector rotation leaders, then an investor might want to become more defensive in their portfolio.
Of course, this could all be for naught. The market could continue to rally indefinitely, but a wise man at least brings an umbrella when rain-threatening cumulus clouds appear in the sky.