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Sector Rotation Analysis and Relative Strength Comparison to the Broad Market using S&P 500 Index

We watch ten sectors of the broad market and monitor money flow in and out of each sector, which ultimately provides us clues to the future direction of the overall market. (aka sector rotation analysis) Each of the ten sectors fall into either the cyclical or defensive category. Technology, Industrials, Consumer Discretionary, Materials and Energy traditionally fall into the cyclical category, where these companies do well when the economy is expanding and do poorly when the economy weakens and/or begins to contract. In contrast, Consumer Staples, Health Care and Utilities fall into the defensive category and these companies tend to chug along at low growth rates regardless of the strength of the economy, and cash will move into these "safe" sectors when there is concern about the health of the economy.

As an example, below we show the daily chart of the Consumer Discretionary Select ETF - symbol XLY. The XLY comprises companies that make products that are not absolutely required to live and are discretionary items such as high-end clothing, fast food, automobiles, and media types of products. Thus, this sector is cyclical in nature and does well when the economy is expanding, and does poorly when the economy slows down and/or starts to contract.

The second chart shows the relative strength comparison of the XLY to the S&P 500 index. The blue dots represent Federal Reserve meetings where interest rates were left unchanged. If the relative strength comparison is trending up it means that this sector is outperforming the broad market, more cash is flowing into this sector as compared to the broad market, and investors believe that the economy will continue to expand.  In contrast, if the relative strength comparison is trending down it means that this sector is underperforming the broad market, less cash (or negative cash) is flowing into this sector as compared to the broad market, and investors believe that the economy will weaken.

When looking at the XLY daily chart we can see that the index rallied hard, it took out a new closing high above the pre-recession high of 40.5, and then pulled back and is attempting to find support at the pre-recession high of 40.5. As long as the XLY holds above its 50 day simple moving average (SMA) near 39.5, it's sending a bullish signal to the broad market.

Per the relative strength chart, this cyclical sector (consumer discretionary) is outperforming the broad based S&P 500 index and it sends a bullish signal to the broad market. As of July 2011, the date of the chart below, even though some of the macroeconomic indicators came in very weak, investors seem to be looking past the weakness and believe that the economy will continue to grow.

In summary, by monitoring how this sector is behaving as compared to the broad market, and by monitoring the other 9 sectors mentioned above, it provides us clues to the future direction of the overall market.