Signs of Sector Rotation Mark a Fluid Sentiment Change

Many professional asset managers, including myself, are self-described students of sector rotation. While both schools of top-down and bottom-up investment analysis exist and can be equally argued for, there is a driving consensus that they both have proven to be effective approaches to investing from a historical basis.

Before we look at the differences between top-down and bottom-up investing, it should be made clear that both of these approaches have the same goal: to filter out great stocks. However, there is a clear difference as to the various strategies used by top-down vs. bottom-up investors to select companies in which to invest.

Top-down investing involves analyzing the “big picture.” Investors using this approach look at the economy and try to forecast which industry will generate the best returns. These investors then look for individual companies within the chosen industry and add those stocks to their portfolios. For example, suppose you believe there will be a rise in interest rates, as is the current prevailing sentiment. Using the top-down approach, you might determine that the banking industry would benefit the most from the macroeconomic changes and then limit your search to the top companies in that industry.

Conversely, a bottom-up investor overlooks broad sector and economic conditions and instead focuses on selecting a stock based on the individual attributes of a company. Advocates of the bottom-up approach simply seek strong companies with good prospects, regardless of industry or macroeconomic factors. What constitutes “good prospects,” however, is a matter of opinion. Some investors look for earnings growth while others find companies with low price-to-earnings (P/E) ratios attractive. A bottom-up investor will compare companies based on these fundamentals. As long as the companies are strong, the business cycle or broader industry conditions are of no concern.

Since most of my work is targeting high-yield income generation, the use of top-down analysis tends to weigh more heavily in my asset selection. The direction of interest rates (macro component) has great influence on certain classes of income assets. I’ve recently lightened up on assets that are more sensitive to deflation and increased my weighting to interest-rate-sensitive assets. Commodity prices (macro component) also have a great impact on how high-yield asset selection is determined. Even though energy pipeline stocks don’t prospect for oil and gas, they move higher and lower with the price of those fossil fuels. It is my view there is a correlation between the “big picture” and “stock picking” that investors need to respect in most investment scenarios.

It is a rare situation when a company like Apple Inc. (AAPL) emerges as a superstar stock, but bottom-up investors love to point to this particular stock that has scored nearly an eight-fold return since the market bottomed out in March 2009.

Comparatively speaking, the S&P 500 has traded from a low of 666 during March 2009 to today’s level of 2,140 for a 2.5-fold return — though the economy has advanced on average about 1.5% per year. There are many small-cap winners with similar returns to those of Apple. But for big caps, this is a short list that also would include Amazon.com (AMZN) and Alphabet (GOOGL).

Looking at the bond market using the 10-year Treasury Note as the benchmark, the yield declined from 7.0% 20 years ago to 1.34% in early July this year. From a panel discussion I attended this past week at the Dallas MoneyShow, the general consensus was that the great bull market in bonds is over. Rates might not move much higher from current levels due to low inflation and slow growth, but it was broadly agreed upon that the easy money has been made in bonds.

Under this assumption, there already is a seismic shift under way within income-producing asset classes that takes into account both top-down and bottom-up analysis and sector rotation. For conventional fixed-income assets, the tide clearly has been going out of long-dated Treasuries and investment-grade corporate and municipal bonds, with levered closed-end bond funds seeing values fall by as much as 20% in just the past two months.

Within the equity markets, there has been elevated distribution of what are termed “bond equivalents,” or stocks of companies that pay lofty dividend yields within sectors that are either considered beneficiaries of lower interest rates or are defensive and non-cyclical in nature. Most of us would know these stocks fall into the categories of electric utilities, telecom service providers, real estate investment trusts (REITs) and consumer staples.

Even though the yield on the 10-year T-Note has only risen by less than half of one percent, and currently is 1.74%, many stocks within these “bond equivalent” sectors have aggressively retreated to the tune of 15-20% off of their highs as well. The selling has been fairly dramatic during the September-October timeframe. Though the selling has subsided this past week, it could resume its intensity as the December Federal Open Market Committee (FOMC) meeting approaches with the current consensus, 65%, expecting a rate hike.

For income investors, there are two old sayings at work here; “Don’t fight the Fed” and “Don’t fight the tape.” I’ve been reducing exposure to fixed income and bond equivalent equities well before the recent slide in these assets, but have retained a few holdings just the same. There are special situations in the utility, telecom, REIT and consumer spaces that will continue to work even if rates gradually rise, primarily because they are demonstrating strong growth characteristics.

This can be seen in utilites that are ramping up revenue from renewables, or in telecom companies that are adding cable, video and digital content. It also can be seen in REITs that target cloud computing and in consumer companies engaged in healthy living, organic nutrition and online e-commerce. It’s safe to say that there is always a bull market somewhere in the stock market, but it also probably is safe to say the bond market and all its sub-sectors have entered a bear market. My Cash Machine investent newsletter is dedicated to high-yield income where capital is best served, and interest-rate-sensitive assets are where investors should find outperformance for 2017. To learn how Cash Machine can help you, click here.

***Publisher’s Note***

I am happy to announce that Mike Turner has joined the Eagle Financial Publications family. Mike and I sat down for a short discussion about investing that you can listen to by clicking here now.

In this interview, you will get to know Mike better and learn a few other things, such as:

• Why most people buy and sell stocks at the wrong time
• Mike’s 10 Rules for Investing that everyone should know
• Why Bloomberg put Mike’s investing “Tools” product on more than 330,000 of its computer terminals
• And lots more!

Listen to Mike’s insights on the markets by clicking here now.

In case you missed it, I encourage you to read my e-letter column from last week about possible mergers and acquisitions in the technology space.