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Craig Allen: A Shift In Market Leadership Could Signal Looming Correction

Stocks performed exceptionally well for 2012, with the Standard & Poor’s 500 gaining 13.4 percent for the year. Interestingl,y this index gained 12 percent during the first quarter, meaning that for the balance of the year, a nine-month period, the S&P 500 only added about 1 percent.

Also of note is the fact that the financials sector, the best performer in the market, gained 26.3 percent during 2012, outpacing the return of the overall market by a factor of roughly 2-to-1. The financials also outperformed the next best performing sector — consumer discretionary — by a significant amount (consumer discretionary stocks were up 21.9 percent during 2012), and by about twice as much as the technology sector, which was up 13.1 percent.

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While health-care stocks gained 15.1 percent during 2012, these stock do not tend to perform all that well during periods of economic recovery, with higher growth-oriented stocks tending to perform better. Financials are particularly important during a recovery, especially in the United States, because we have a credit-driven economy. We need the financial companies to finance our growth, so it would be very difficult for our economy to recover without the financials participating.

In the nearby chart, we can see the financials sector (blue) compared with the S&P 500 (orange). In this chart, the positive impact of the agreement on the “fiscal cliff” is evident, with a jump in the financials sector and the overall market, at the beginning of 2013. Since that initial pop, stocks have been fairly flat. However, we can see that the S&P 500 has continued to rise, while the financials have lagged slightly. While this difference is subtle, it could be an early indication of fading leadership by the financials sector.

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?The next chart shows the second best performing sector — consumer discretionary — as compared with the S&P 500. This sector has continued to perform well, actually gaining a bit more than the overall market during the period following the fiscal cliff reaction. This positive performance supports the view that this rally has legs and could continue for some time.

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The next chart compares the technology sector to the S&P 500. In this chart, the divergence between technology stocks and the broader market is much more evident. While the S&P 500 has continued higher, tech stocks have actually declined since the fiscal cliff jump. Historically, tech stocks tend to perform best out of all sectors, in a recovering economy. This is because as a group they tend to have the highest rates of growth for revenues and earnings out of all sectors.

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For the stock market to continue to rise from current levels, we would expect to see the sectors with the strongest growth prospects lead the market, moving together, and outpacing the growth of the overall market. Although consumer discretionary stocks are exhibiting this behavior, we are not seeing financials and especially technology stocks reacting as expected. Without confirmation from these key sectors, it is hard to justify expectations for continued upside to the market from current levels.

Stocks are currently trading at better than five-year highs, with the S&P 500 closing last week at 1,486, just 79 points, or 5.3 percent, from the all-time closing high. Economic growth is estimated to be 2 percent in 2013. This assumes there is no negative impact from any spending cuts that may be implemented as a result of the fiscal cliff/debt ceiling negotiations. Any significant spending cuts could easily erase any potential growth from the economy this year.

We also have the threat of one of the worst influenza outbreaks in at least a decade. Some economists estimate that a really bad flu could drop growth of gross-domestic product to 0.5 percent from 2 percent. Again, this does not include any additional negative impact from spending cuts or other measures resulting from the fiscal cliff and debt ceiling debates.

We are also in the midst of earnings season, with fourth-quarter earnings reports being reported over the coming several weeks. So far, earnings have been mixed, with only a small percentage of S&P 500 companies having reported earnings as of the end of last week. Early indications are that earnings are slowing, reflecting the uncertainty surrounding the end of 2012 fiscal cliff struggles in Congress, and Hurricane Sandy’s impact on the economy. Consumer spending over the holidays was weak, which will certainly hurt revenues and earnings for retailers that are the core of the consumer discretionary sector.

By keeping an eye on these key sectors, investors can track the leadership in the stock market. If these key sectors fade, it is a good bet that the overall market will follow closely behind. By combining an analysis of this sector activity with a monitoring of earnings and the fiscal cliff and debt ceiling debate outcomes, investors can make more informed decisions about the future direction of the markets, and can, hopefully, protect their portfolios from significant losses.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.

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