Morning Notes — Defensive Sector Leadership Casts Doubt

Sector divergence: The S&P 500 made new highs last June and July on defensive sector leadership. At the time, we cautioned readers about the sustainability of new highs built on defensive sector leadership. This common sense idea was first presented at Dow Theory during the early 1900s and based on divergences between performance in the Dow Jones Industrials (INDU) and the Dow Jones Transportation Average (TRAN). Transports like railroads were highly cyclical and their outperformance vs the broad market would signal an expected pickup in growth. Buying into Dow Theory or our modified version that measures the performance divergence between the S&P 500 (SPX) against the Philadelphia Semiconductor Index (SOX) requires an appreciation for the collective intelligence of markets and some time to test/measure the signal quality of market internals.

More: The S&P 500 has already staged a strong rally from the support levels (~3150-3200) we discussed in our notes from 1/17 and 1/23. The rally from those levels coincided with reports of a deceleration in the day-over-day growth rate of confirmed coronavirus cases. The deceleration suggested some success in the policy-driven containment efforts and was the first indication the economic impact on China could be confined to Q1. Today’s message from the WHO that the number of overall cases declined for the first time yesterday is even more encouraging. After 35 years of testing market internals, the new highs in the S&P 500 are only encouraging if confirmed by cyclical sector leadership. Importantly, the markets and sectors most closely aligned with the global economic cycle have only retraced portions of their coronavirus-lined decline. As noted in the previous paragraph, we’d keep an eye on the SOX but also the Nikkei 225 (NKY), German DAX (DAX), SPX sector leadership, Russell 2000 Index (RTY) and the MSCI World Auto Index (MXWO0AU) in the days ahead. Btw, the relatively esoteric MXWO0AU has completely recovered and more, but think it makes sense to wait for a few others before adding broad equity exposure.