Continued Split Market or New Leadership during the Second Half?
Economically sensitive cyclical sectors benefited the most during the first quarter on the backdrop of signs of stabilization in the Covid-19 pandemic and a rebounding economy. Other cyclical groups such as Industrials also jumped higher in anticipation of Biden's Infrastructure stimulus plan. Rising commodity prices and fears of inflation ignited a sharp rally in Energy and Materials. Interest rate-sensitive sectors, including Financials, also excelled as interest rates trended higher.
With a few weeks before the halfway mark of the year, the year-to-date returns continue to show investors favoring Energy (XLE – 40.50% year-to-date), Financials (XLF – 28.04% YTD), Materials (XLB – 20.70%), and Industrials (XLI – 18.09%).
The laggards for the year remain situated in many of the defensive areas such as Consumer Staples (XLP – 5.30% YTD), Utilities (XLU – 5.79% YTD), and Healthcare (XLV – 9.00% YTD). Surprisingly, Consumer Discretionary (XLY – 9.67% YTD), and the economically sensitive sector have fallen behind and are now underperforming SPX Index (SPY – 12.45% YTD). The rotation from growth to value this year continues to hurt the structural growth Technology sector (XLK – 6.25% YTD), at least from a near-to-medium perspective.
Will the above trends continue during the second half of the year or will there be a change of leadership?
The Relative Rotation Graph (RRG) over the past 17 weeks to the beginning of the year suggests some of the leaders of the past 4-plus months can continue to lead during the second half. However, there are also technical signs to support a near-term shift in leadership roles in some of the laggards.
It is reasonable to expect the cyclical sectors to lead the market in a recovering or strengthening economy. The Industrials (XLI) continues to maintain its leadership role within the Leading Quadrant. However, the Consumer Discretionary sector (XLY) has been erratic this year. It was relatively strong to start the year in the Leading Quadrant but quickly slipped into the Weakening Quadrant and then into the Lagging Quadrant. However, it is now showing signs of turning as the relative momentum trend has picked up. The relative performance of XLY will help to decide if the reopening of the economy and the reopening trade sustains into the summer as so many are projecting.
Within commodities, Materials (XLB) has moved decisively into the Leading Quadrant, and Energy (XLE) has slipped into the Weakening Quadrant. Although the Energy sector can still trend higher, investors may become increasingly selective into the second half prolonging the split market environment in commodities.
Defensive sectors such as Consumer Staples (XLP), Utilities (XLU), and Healthcare (XLV), which have consistently lagged among their peers over the past few years, are showing signs of emerging. The sharp rise in relative price momentum trends in these sectors hint of emerging leaderships possibly during the sell in May and go away seasonality weakness period. XLU and XLP remain entrenched within the Improving Quadrant, while XLV is within striking distance of entering the Improving Quadrant.
Interest rate trends will continue to decide the outcome of the interest rate-sensitive sectors. The leadership Financial (XLF) sector is close to slipping into the Weakening Quadrant, suggesting an overbought condition in need of consolidation. On the other hand, the high dividend-yielding Real Estate (XLRE) sector recently moved from the Improving to Leading Quadrant, suggesting investment interests from a near-to-medium term perspective.
Although the Technology Sector (XLK) retains its long-term structural growth trend, it remains lackluster this year. Rising interest rates, inflation concerns, and overbought conditions continue to hamper this sector. The competition for money from value-related sectors is another reason for the near-term relative underperformance. The Communication Services (XLC – 15.33% YTD) have performed better than Technology this year. But the sector is moderately overbought, and its recent decline into the Weakening Quadrant warns of near-term relative underperformance. If XLK shows signs of stabilizing within the Lagging Quadrant and begins to improve, will investors and traders return to the Technology sector during the summer months?
Time will tell if the above sector rotation trends are near-term and transitory or longer-term and sustainable.