Summary The economy remains resilient. Earnings have been decent, specifically against lowered expectations, but profit margins are near peaks and are flattening at best. Sector rotation characteristics are generally bullish but have been exhibiting a lot of back and forth action the last few months, indicating an ongoing bull/bear fight. Sector and Stock Market Background (primarily for new readers) If you’ve read me before and understand the “primers” and Sector Rotation Theory/Model, you can skip to the next section (Current Market). If you are a new reader, Chart 0 below shows the sector rotation principle. For a quick read on understanding of the principle and causes of sector rotation, please see the “Sector Rotation Background” in this article (at the very top), but I would recommend you skip it and go straight to the more comprehensive “must read” article on sector rotation in a bear market , which was my first published article. It is a “primer” article to understand the principals, and realities, of sector rotation as well as aspects of “behavioral finance” and long -term stock market behavior. I also have two other “primer” articles you should read, one on ” secular equity markets ” to understand long cycles in the market, and one discussing the importance of secular interest cycles and their effect on the stock market. Being “primer” articles, these articles are long; investing is a marathon, not a sprint, it takes preparation. The secular equity markets and interest cycles article are basics everyone must understand. Sector rotation is a more advanced topic. Chart 0 – Understanding the Sector Rotation Model The “sector rotation in a bear market” was my first published article, written in response to another Seeking Alpha article, and it received the most readers because it was an Editors Choice. I wrote the “secular equity markets” to build on some points I touched on in my first article but deserved greater explanation. Finally I wrote the “secular interest cycles” to wrap it all up, to fill in the final piece of the puzzle. However, the order in which I wrote them is essentially backwards. The big picture starts with how secular interest rate cycles affect equity markets, then how equity markets experience long bull and bear periods in a large part due to the interest rate cycles. Once you understand these basics, then understanding sector performance can give clues to where the stock market is headed. Current Market Performance and Some Economic Stats I’ve been calling the market schizo because one day good news is good news (earnings, mostly), the next day, bad news is good news (the Central Banks of the world, either pursuing or talking about further easing, presumably due to slower than desired economies – which are slowing further? – with the possible exception of our FED, which is on the cusp of insignificance because it has continually been “all talk, no action”). With earnings season winding down, the market is now back in a “bad news phase.” I have cleaned up the chart below, but the W and now down has followed this basic reasoning: (1) Down in Mid-AUG: China is slowing = panic; (2) “Up” until mid-Aug: there was actually a big swift bounce once the panic was over, but then China’s PMI hit a six-year low and we fell back, only to slowly rally (mostly) until the FED announcement on Sept.17th; (3) Down until Oct: fairly hard drop after the FED did not raise rates; (4) Up until recently: The SPY sort-of made a double bottom, ignoring “crash Monday’s” long tail, then popped up for 2 days, but the very poor employment number on Oct. 2nd first tanked the market but then it soared intraday and never looked back; EC bankers made easing noises a couple of times, and China cut interest rates and reserve requirements, further boosting the market; (5) Recent turn down: While earnings had been helping, the big drop appears to have mostly been attributable to weak retailer earnings and sales. Chart 1 – Main Index ETFs: DIA , [ SPY , [ IWM , QQQ (click to enlarge) Note on chart enlargement: Right-clicking and selecting “open in new window” (or tab) seems to “right-size” all charts plus you can use “cntl+” and “cntl-” to zoom in and out and move around. This works for the 3 main browsers, whereas simply clicking to enlarge may have issues — i.e., I find the chart slightly too large but I can not move it around. Truly, the best explanation of the pullback that I can find is that sophisticated funds started going long as the VIX approached lows: During the month of October, the gamma exposure of put options declined significantly (and gamma of call options increased), such that the net effect of option hedging has been muted… “Option hedging being muted” means it is not working as well, so buying puts is not protecting your portfolio as well as it use to do. During the panic and “crash Monday”, the Vix soared as did the put/call ratio as investors sought to hedge with puts or outright bet on a declining market. The reason I think this is a better explanation is that it was said on Thursday November 5th, or in other words, it was said with foresight; the strategist in the article apparently has great foresight. Besides, all indications at this point are say there was a short-term panic and as it subsided, people sought to “buy the dip” (‘BTFD’ in less polite terms). The real slide seemed to start on Monday, November 9th,, and you can pick your poison when trying to explain the causes of market moves, but when a reuters story postulates that the ECB is going to go “further into the red,” pushing interest rates deeper into negative territory (ZIRP becomes NIRP becomes even greater NIRP), this is very negative news to me. It trumps all others. Here is some of the other news Good news: Jobs have been growing (there’s a “but” and it is the growth came from the over 55 age bracket and the core brackets are actually losing jobs); however, jobs is a lagging indicator. Housing is also strong , notably in terms of recent employment gains and prices, but in terms of actual sales and starts, the strength is in comparison to the lows reached in the financial crisis and “not so much” in comparison to pre-financial crisis levels. And US auto sales are around record levels. Here’s the bad: Manufacturing is weak and often leads the economy into recession , and is reflected in slowing transportation indices (Chart 2), which is perhaps being driven by slowing imports and exports, especially among commodities (Chart 3). While the data lags by several months, changes in private debt leads or coincides with changes in GDP , and the latest info through June shows debt growth deceleration. Chart 2 – RR Carload and Intermodal Traffic and Cass Freight Index (click to enlarge) Chart 3 – GDP, Imports and Exports (click to enlarge) Remember “math”: the large percentage declines of the financial crisis make for easy comparisons, so the 2010 GDP and import/export increases are not too impressive against easy comparisons; however, 2011 strength was solid and looks fairly strong in comparison (ie, building on improved results). Perhaps the 2012 weakness was difficult comparisons, but for the last 18 months it looks like imports and exports have been getting weaker. Chart 3A below is not meant to be a very readable image. Rather, it has a single point which is fairly simple. Assuming that stock markets are a reliable economic indicator, among the emerging countries of the world, on the right, not a single market has a positive return over the last 12 months (the big black horizontal line is the zero return line). Among the developed world, on the left, only a few are positive, with “the flying PIIG” of Ireland being the strongest. I would be remiss as an Austrian if I did not point out that Ireland has taken a different path in this world of QE and that path has been one of austerity. The developed markets near the bottom of the list are all commodity related. So if stock markets lead the economy, indications are negative. Chart 3A – Developed and Emerging Stock Markets (click to enlarge) Justification for US economic strength has been the consumer, and in particular, motor vehicles have been especially strong (see chart 4 below). Retail sales excluding autos are getting weaker, as has been evident not only in the recent retails sales number disappointment but also in the disappointing earnings of some retailers. Excluding food services sales in Chart 4 and retailer sales are almost flat (American dollars spent eating out have recently surprised dollars spent in grocery sales, which may explain both where fuel savings have gone as well as why employment in restaurants remains strong). Chart 4 – Retail Sales. (click to enlarge) The Atlanta Fed’s GDPnow forecast for the 4th quarter GDP exploded from 1.9% to 2.9% after the strong employment number but has dropped quickly back to 2.3%. This model is new so it needs more time for validation, but its 2nd quarter estimate was a good one and it gained notoriety for its 1st quarter prediction, which handily beat the far too optimistic estimates of Wall Street. Overall the American economy is still moving forward. Earnings and Sector Performance Around 92% of companies in the S&P500 have reported earnings for the third quarter. Around 70% have beaten estimates (Factset: 74%, S&P Dow Jones Indices: 68.5%) and both services project 4th quarter declines as well. Factset currently projects a 1.8% decline in Q3 earnings on a revenue decline of about 4% (S&P Dow Jones Indices releases a spreadsheet with limited commentary, and with different adjustment methodologies, for specific commentary I will rely on Factset unless otherwise noted). Chart 5 – Factset’s Projected 12 Month Forward EPS and the S&P500 Price (click to enlarge) Click here to receive this report via e-mail. The chart 6 below shows the change in the forward 12-month EPS for each sector compared to the price change since June 30th. I find this diagram interesting although I would not yet describe it as helpful because there has been noticeable movement in relative positions in just 1 week (and the colors are Factsets, not my usual). With that caveat, Energy (NYSEARCA: XLE ), in purple, and Materials (NYSEARCA: XLB ), in Tan/Goldenrod, have experienced the largest decreases in EPS estimates (around -5.0%) while at the same time experiencing the largest prices increase since June 30th (~8-10%), likely due to beating analysts depressed estimates. Technology (NYSEARCA: XLK ), in gray, has moved into a tie for 1st place in terms of performance, but the projected change in EPS estimates has dropped from about 2.5% last week to flat. The Consumer Discretionary sector (NYSEARCA: XLY ) has seen its EPS estimate move up since last week, so perhaps will shake offits recent sluggishness and resume its leadership role. Chart 6 – FactSet Price versus EPS changes (click to enlarge) Chart 7 below shows the actual EPS per share for each sector, broken into cyclical and non-cyclical sectors to try to make the charts more readable; however, the bottom section has Excel-determined trend lines to help understand the trend directions. Please note the SPY is on the right-hand-side and the scale seems deceptive, although the large losses in several sectors during the financial crisis may explain the large slope. Looking at a percentage change chart for the last 7 years (not shown, and excluding 2008 which is in the chart below), the best performing sectors were: Discretionary around 280%, Health Care (NYSEARCA: XLV ) and Technology , both around 180%, or roughly what is shown by the better EPS trend lines in Chart 7. Two of these three are cyclical sectors, and Health Care appears to be playing catch-up after an Obamacare-depressed period. Finance (NYSEARCA: XLF ) also appears to have a strong trend based on the depths of its earnings depression during the finance crisis, and as you can tell below, XLF is the 3rd best sector on a 3 year percentage change chart. Chart 7 – S&P Dow Jones Indices Sector EPS (click to enlarge) Note: The HTTP references to source material from S&P Dow Jones Indices/SPDJI refers to the S&P Index page where the data file link under “Additional Info” – “Index Earnings” will start a direct download of the SPDJI EPS data spreadsheet. Generally speaking, the market continues to have a bullish undertone with respect to earnings announcements, as earnings beats have seen around a 2% increase in stock price centered +/- 2 days around the release date versus a 5 year historical average of around a 1% increase in the stock price. Conversely, negative surprises have resulted in about a 2% decline, or about 30 basis points less than average. Good news is good news, and bad news is not so bad, for earnings announcements. Chart 8 below shows the specific sector beats for the 3rd quarter (tan in color) versus the 14 quarter average (black), with beats that exceed the average in green and misses (compared to the average) in red. Generally speaking, the longer-term trend in earnings often determines the ultimate stock price direction (in the long term), although short-term beats and misses determine the more immediate short-term direction, as we have witnessed in the Energy and Basic Materials sectors, which have poor longer-term earnings trends but reacted very positively over the last few weeks as earnings generally exceeded expectations. I have read that academics studies investigating the 1-month price momentum phenomena (persistence of outperformance) speculate it is due to the markets lack of emphasis on quarterly earnings performance (but I have not yet had time to read the research). Regardless, don’t underestimate the importance of quarterly earnings cycles. Chart 8 – SPDJI S&P 500 EPS Beats and Misses by Sector (click to enlarge) Note: If it’s a miss (red), it’s to the right of the tan/black histograms; beats (green) appear to the left. The average beat rate is a simple 14 quarter trailing average without any seasonality adjustment. It is important to understand that a significant factor in EPS growth continues to be the level of stock buybacks. SP Dow Jones Indices cites 68% of the S&P500 companies (312 of 458) as having fewer shares outstanding this quarter when compared to a year ago. Fully 22% have a reduction of 4% or more, for the 7th quarter in a row. A Reuters study shows that many companies are investing more in share buybacks than in R&D and other capital spending. This would certainly explain the sluggish growth in employment, where buybacks do little or nothing for job growth whereas capital investment has been shown to help generate jobs. Almost 60% of 3,297 public non-financial companies bought back shares since 2010 and in 2014 spending on buybacks and dividends exceeded net income for the first time outside of a recession. As I read this article I could not help but think how much we need Washington to incentivize R&D and capital investment through the tax laws, and I laughed when I saw that Senator Warren wants the SEC to look at buybacks as a potential form of market manipulation, but I was pleasantly surprised to see that Hillary wants companies to shift their focus to the long term. So do I, I just wish Washington and the FED understood that “there is no long term” when interest rates are near zero, not in terms of returns on capital and “Buzz Lightyear” payback periods (“To infinity… and beyond!”). Chart 9 – Net Margins (click to enlarge) In addition to the boost to earnings from buybacks, the lack of R&D and capital spending (and lack of new hires?), also contributes to better margins, as shown in Charts 9 and 10 above and below. Longer-term views of margins have them at or near all-time highs, with much speculation as to when they decline. Energy and Basic Materials margins have already begun to decline but other sector margins look healthy. The Tech sector is showing a sharp rebound; the information I have shows Apple (NASDAQ: AAPL ) profit margins looking stable over the last few years, but with all “the negative attribution” of Energy on S&P 500 profits in the last few weeks, I would love to know how Apple plays into the profitability of Tech; you’ve probably seen the case made where removing Apple’s profit from the Tech sector significantly reduces the sector’s profitability. Health Care’s slightly declining operating margins appear counter intuitive and need further explaining although at this point I don’t have an explanation. The Financial sector, like TECH, had to be put on the right-hand-side of the charts below because their margins are significantly higher than the other sectors. This would seem to imply better stock performance for the Financial sector going forward. Chart 10 – S&P Dow Jones Indices – Operating Margins by Sector (click to enlarge) Finally, before moving to the sector percentage change charts, below in Chart 11, I have the PE-to-Growth ratios for each sector, on the left. The right side shows what the actual operating PE is along with the projected growth in EPS. The lower the PEG ratio, the better valuation there is in the sector. This translates to the right side as “the higher the green (growth) relative to the purple (NYSE: PE ), the better”. The highest projected growth (green) is for the Discretionary sector, and it is about equal to the operating PE (purple), and this means the PEG ratio is the lowest one, around 1 (and it is in the sector colors I use, where cyan/blue is the XLY color). Generally speaking, this implies the Discretionary sector has the best valuation on a PEG ratio basis; however, it would be preferable to weigh the XLY sector PEG ratio against its own historical range (I don’t have enough data yet). This principal is perhaps most evident in Utilities (NYSEARCA: XLU ), which can almost always be expected to have the lowest growth rate, making the XLU PEG ratio look unattractive; however, you have to remember that there are at least two other attractions to the Utility sector: (1) higher dividend yield and (2) greater stability (it is almost certain that you need utilities even in a recession). Aside from this caveat, be aware the Energy PEG ratio is meaningless with significantly depressed/negative operating earnings and a low growth rate. The Tech sector and Health Care sector appear to have the next best EPS growth rates, although you will pay a little more for them. Chart 11 – PE-to-Growth (NYSE: PEG ) Ratios for Each Sector (click to enlarge) Overall, earnings have generally been good and even better than expected where they have been weak (XLE, XLB). On a PEG to growth rate, valuations seem attractive. Initially earnings seemed to be helping the market rally, but as earnings season comes to a close, the market reversed back down as I discussed earlier. And as I write this Monday night, after the markets surged today – on no news – it seems the market is reacting as much to technicals as it is to fundamentals, at least short term. After last week’s poor showing, the market was washed out in the short run, but let’s look longer-term first. In “Tart” 12 (a “table/chart” – focus on colored return boxes along right axis), Discretionary/XLY (cyan color), Health Care/XLV (red) and Tech/XLK (purple) are the generally better performing sectors. Discretionary has been the long term winner, although it weakened some with the recent correction, not that you can tell in the chart below. Health Care has been strong post-Obamacare concerns but it weakened recently with its newly found attention in Washington (which may continue as a negative drag since it’s an election year). Tech found recent strength in this reporting season, helping to move it higher in the longer-term rankings. Finance is the 3rd best sector in the 3 year chart and contrary to what some may believe, it has done fairly well off the financial crisis bottom. Tart 12 – Sector Performance Longer-Term (click to enlarge) In the shorter-term percentage change charts below, the last 4 weeks shows Utilities at the bottom. This is perhaps the single most reliable sector indicator of where to position yourself in the sector rotation model. If Utilities are performing well, be bearish in general, and vice versa. Utilities are currently lagging in this 4 week chart so they are sending a bullish signal despite the pull back last week. Staples (NYSEARCA: XLP ), another sector professionals like to hide in, is also lagging, signaling a bullish perspective. Bunched at the top are brown, purple, dark blue and red, better known as Materials, Tech, Industrials and Healthcare. These are cyclical sectors (ex-XLV) and only Discretionary is missing (which has been weak across the board, a possibly bearish indication). The 2 week picture is less clear and the 1 week has Utilities at the top, reflecting last week’s dismal performance. Since we’re looking for clues to a turn in the market, the focus is one the short-term picture, which is still mixed. Tart 13 – Sector Performance Shorter-Term (click to enlarge) Despite this confusion, the ratio charts are less unclear. IF you’re not familiar with them, I’m made them simpler by aligning the colors and directions. Each panel in Chart 14 has the S&P500 at the top, then the “pairs ratio” symbols (green is the bullish ticker), followed by two ratios at the bottom, a shorter-term one and a longer-term one. The left panel below is the SPY/XLU ratio, and if the SPY (green) is outperforming the XLU (brown), be bullish (foreground is a daily chart that goes back to end of August, the background chart is weekly and just shows since “the crash”). The middle panel is Industrials (NYSEARCA: XLI ) to Utilities , and the right panel is Discretionary to Staples . Except for the weekly XLI/XLU, every ratio is a buy. At the same time, to really understand these charts, you have to realize the blue line is an actual moving average of a ratio line, the slow one, and the black line is the fast ratio moving average line. Therefore, the black and blue lines will move before the signal line gives a signal, and while almost all the signals are bullish green, the black lines have crossed under the blue lines (mostly) and the blue lines are headed down (mostly). What this reflects is we had a strong rally off the late September low (signals went green), but we had a bad week last week (the blue lines are singing the blues, by turning down). Basically this says be bullish but cautious. Chart 14 – Ratio Charts (click to enlarge) The are many other ratios you can look at, and 3 of the most popular are transportation stocks relative to the averages (sort of a Dow Theory off-shoot), high beta (NYSEARCA: SPHB ) to low volatility (NYSEARCA: SPLV ), and Junk bonds (NYSEARCA: JNK ) to (liquid) Corporates (NYSEARCA: LQD ). They too have been trying to change direction, but in this case, they’ve been trying to go from bearish to bullish, but mostly they are failing and rolling back toward bearishness. I would not be too quick to write off the power of these ratios since they are widely followed, even in the hedge fund community . Given the volatility – and variability – in the sector rotation leadership, the signals are still unclear. Or perhaps that is the signal itself; we are in a bull and bear fight, and it is still unresolved. Remember, a secular bear market mauls you, down and up, down and up, again and again. I remain cautious given my long-term secular concerns. Note for readers: Only “real-time alerts” followers receive e-mails notices of posts to my Instablog, where I am trying to publish more frequently.