ARE CYCLICALS THE NEW RHYTHM AND SWING?

That retail investors are reentering the equity mutual fund market has been extensively reported since last December. As the author wrote in January of this year, retail investors “make investment choices based on their concerns about their future wages and future investment returns. This means that changes in the economy and changes in the equity premium affect fund choices—an observation certainly confirmed by many retail investors’ recent personal experiences.”

REUTERS/Goran Tomasevic

Institutional investors, especially the 200 or so largest players in the U.S. stock market, do not tend to be as affected by recessionary episodes. So, where are they putting their money these days? Into dividend-paying stocks such as the DJI 30, the S&P 500, or the R2000, whose dividends are 6%, 5%, and 10%, respectively? Or are they moving further into risk-on territory. These investors are the ones who more than likely were the major players in last year’s U.S. stock market rise. Could it be—as some analysts claim—that, unlike retail investors, institutional investors are moving away from dividend-paying stocks (such as the equity income funds retail investors are still favoring) and into cyclicals?

To answer these questions we use data from Lipper to look at the U.S. exchange-traded fund (ETF) market as a representation of institutional players’ preferences. (This is not an uncommon characterization, according to comments made by Lipper analysts over the last several years.) If institutional investors are becoming increasingly risk-on players in the cyclical market, one would expect them—given the current stage of the U.S. economic recovery—to be moving into retailers, financials, and consumer discretionary stocks. Using the traditional tools of quantitative or fundamentals analysis, the evidence for this kind of move is at best tepid. Instead, we use a more advanced tool that combines price and volume, giving deeper insight into market momentum. Imagine being hit by a bike going 18 mph versus being hit by a 16-wheeler going 18 mph. Your body is going to suffer far more damage from the 16-wheeler because of its weight. The weight—in stock or ETF terms—is the volume traded. Another aspect of our calculations is energy. Consider the energy produced by a windmill versus that produced by a hydroelectric dam. The amount of energy in the market does vary and can indicate whether there is a potential to move forward, signaling a clear “oomph” in the market, or whether the energy has already begun to be released.

Using our tools, we see both the financial and consumer sectors going through some good rhythm and swing. There is a difference, however, in terms of the oomph each has. Financials are becoming increasingly energetic but only over the shorter term—20 days or so. That their energy does not extend over a broader spectrum—three months or so—may mean financials will be susceptible to overall market reversals. So, while the financial sector is doing well, it may be more fragile and hence more susceptible to external sector movements.

On the consumer sector side there is evidence of a good recovery and a confirmation that the U.S. economy is indeed regaining strength. The energetic nature of consumer stocks is supported on both a momentum and energy basis, with the energy basis covering both the short term and the intermediate term. This is a good sign for the U.S. economy.  Finally, we see good strength, both momentum and energy related, amongst industrials.  These can be taken as a good sign but they possibly be a little premature, a case of the market getting ahead of itself, given the commonly accepted state of the U.S. economy at this point.  However, this week, news stories emphasized that U.S. firms are stepping up hiring, so the industrial energy and momentum analysis maybe picking up early signals of what is often considered a stage two event of the U.S. economy recovery.

Our study indicates that price and volume movements of U.S. sector ETFs give evidence of increasing risk-on behavior by institutional investors. Clearly, there are obstacles in the way. For example, the potential sequester in the U.S. and the uncertainty in the EU on the outcome of the Italian election are troubling, but good economic news continues to come out of the U.S. and China as both economies gain strength. Should these economies not continue to grow, our analysis could be repeated to see if institutional investors are becoming risk-off in terms of stocks, in particular those stocks that typically signal a recovering U.S. economy.