Rotation versus Correction

This past week the markets have seen increased volatility intraday, but only a marginal increase in volatility overall… at least that is true using the VIX (volatility) index as a benchmark. The range has been 12.4 to 15.3  and the current mark is 13.5. Nothing dramatic, but it did capture the attention of investors. The headlines were full of doomsday calls for a correction and more selling on the way. In fact, the S&P 500 index declined only 1% on the week… not too scary is it? Then why the selling in equities? Mutual funds have seen steady withdrawals from equity funds over the last several months according to ICI (Investment Company Institute). This all begs the question: What is going on in the markets? I am not sure we have enough time to discuss the answer in its entirety. The simple answer is rotation of assets from one sector to another… and some to cash. Investors are worried relative to the lack of clarity going forward based on the economic data, the Federal Reserve with interest rates, and earnings for the first quarter. Add it all up and money is looking for a home with less risk or least the perception of less risk. Sector Rotation is a key part of markets maintaining trends longer term.

This week earnings from the internet sector (FDN) has been hit by earnings. The component causing the most grief is social media (SOCL). Earnings from Twitter (TWTR), LinkedIn, (LNKD), Facebook (FB) and  Yelp (YELP) put the downside in play. The ripple effect is of course to the technology sector (XLK) which gave up the role of leadership this week. Throw in the weakness in semiconductors (SOXX)  and you understand the weakness experienced in the sector short term. How this unfolds is of interest as this is one of the largest sector in the market. Thus, it carries more weight in the major indexes impact going forward. From my view the jury is still out. Yes, we have seen rotation from the sector and sub-sectors above, but, you knew there had to be a but, the sideways trend is holding up currently and unless XLK breaks below the $39.85 key support level it still offers opportunities when the dust settles. I am looking to see if only the hot money (short term traders) is moving from the sector or if the longer term investors are leaving the sector. Break support and the latter is the bigger concern. For now, I would be digging for the opportunities left by the exodus this week.

Biotech (IBB) has been another sector experiencing selling. The ETF fell to $333.70 support this week and held. The hard part of that was the decline measured 9.2% before bouncing off support. That gets everyone’s attention. We hit stops on our holdings in the sector as a result of the decline, but we now have to see how it unfolds going forward. The rotation from biotech obviously moved up the food chain impacting healthcare (XLV) as a sector, pharma (XPH) and the Russell 2000 index (IWM). The Russell 2000 broke key support levels at 1225, also hitting our stops. Money has a level of pain and if it hits it… the exodus grows in size. It is like the joke about ten cats in a boat and one jumped out, how many were left? None, they were all copy cats:) That defines selling in the markets when it hits critical levels. Some of the acceleration (speculation on my part) is likely attributed to profit taking, after all this has been one of the best performing asset classes. We hit our stops in conjunction with protecting gains. That is just sound money management. After all, we can buy it back if the opportunity presents itself.

Interest sensitive assets is another area of the markets that has been under pressure. The assumption, threat or promise of the Federal Reserve to hike interest rates has been on the table since first quarter of last year. As the time is believed to be closer these assets are experiencing money rotating out. Treasury bonds (TLT, IEF) are the most obvious to get hit by this type of move. But, it goes deeper than that! Bonds (BND) overall are subject to interest rate risk and it is reflected in the chart. REITs (IYR) are another sector that has felt the far reaching story on interest rates and have decline as well with money heading for the exits. Mortgage REITs (REM) have seen exiting funds as well. The point is know where the danger lies as the story line unfolds. This is one sector I am not looking for the opportunity yet… unless it is to be short (SRS, TBT) and benefit from the money leaving.

In the end it begs the question: if money is exiting or rotating sectors, where is it going? Again you have to look at the charts and money flow for the answers. If we take the last week as an example, money leaving these sector can be seen in the rise of sectors like China (FXI), Russia (RSX), Energy (XLE), Crude Oil (OIL), Base Metals (DBB), Uranium (URA) and of course Cash. Money will migrate to where it is treated the best. The key is not to attempt to chase hot money or sectors, but to look for sustainable developments within sectors. The global story line is gaining momentum, base metals and commodities as well. It is always a matter of doing your homework and looking for the opportunities as they unfold.

The point of the post is not to focus on where to put our money now, but to see how rotation impacts the markets and at times can give the false impression we are heading for a correction. Corrections are built on money heading to cash not other sectors. If money flow out of one sector is found by money flow rising in another, the market is rotating, but money is staying invested. It is when money rotates to safety that we have to raise the warning signs of a correction developing. Watching where and how money is flowing in the investment markets is key. What has happened this week is seen as rotation (my view) currently, but that is subject to change just as easily going forward. Thus, the importance of understanding risk relative to time horizons, as well as, risk relative to markets. We continue to take this one day at a time and let the trends define where our money resides short term or long.

Have a good weekend!