Sector Rotation

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We saw several inflation reports in a row coming above estimates. It didn’t matter much in February as most stocks continued higher. The narrative seems to be changing in the middle of March. Interest rates began to rise quickly last week. This time, this was coupled with weakness in small caps and tech stocks and a rise in basic materials and energy. Is the inflation trade back on? I doubt it is sustainable for too long but it is the current trade. The Fed meets On March 19 and 20th and it is expected to keep the rates where they are. They will surely extend the status quo longer if there’s any doubt that inflation has a chance of rising again. 

We are likely still in a bull market. Even bull markets correct. In fact, the best risk-to-reward entry points during bull markets come after a slight 5-10% pullback in the major indexes. I’d be thrilled if we see one over the next 2-3 months and get the opportunity to buy some of the market leaders near their YTD VWAP.

The market is in a pullback mode, breakouts seem to be failing, pullbacks to major moving averages are not holding, more and more earnings reports are getting sold, volatility and choppiness have increased. Long swing trades have become more challenging in tech but are still working well in energy, metals, and retailers, at least for now.

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Volatility Is Picking Up

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We are in a strong bull market. Even exceptionally sound markets experience the occasional pullback that shakes the exuberance out and resets the bases for many stocks. The price action last week tells us that we might be entering such a corrective, consolidation period. All of a sudden we started to see an increasing number of stocks sell off or not follow through after decent earnings – MDB, MRVL, AVGO, COST, CRWD, etc. Volatility also picked up. Just last Friday, we saw NVDA going from +5% to -5% for the day. COIN went from +12% to +6%. QQQ went from +0.6% to -1.5%. 

We have to keep in mind that bull markets often correct through sector rotation. We saw it last week again – when tech pulled back earlier in the week, financials and basic materials were strong and breaking out. When tech bounced back, financials went sideways. Such types of rotations are healthy. They show that capital is not leaving the market but merely looking for better risk/reward opportunities in various sectors.

There are two most likely scenarios for the next week:

  1. We see a slight correction. The silver lining here is that the best entries in a bull market come after pullbacks.
  2. We see a continuation of strength with rotation in sectors that haven’t participated as much. Quite a few retailers are still due to report earnings. TGT gapped up. GPS gapped up. We might see more of those and a follow-through in the strongest gaps. 

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Small Caps Join the Rally

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The small-caps Russell 2k finally closed at new 52-week highs. The recent drop in interest rates is an essential factor. IWM has been making higher lows and higher highs above its rising 50-day moving average and it is now setting up for a major breakout above 206. If this happens, it will only accelerate the current risk-on mentality. There’s always the chance of a false breakout but it would play out in several days, even weeks. For example, if IWM goes 210 and then quickly reverses below 200 and then below 195, we might see a swift downside move. As of now, things are pointing higher, and more stocks are likely to join the current melt-up that we are experiencing in the market. 

This rally is not just about semiconductors which have been the clear leader year to date. Software, biotech, retailers, and industrials have also been advancing steadily. Even energy stocks are trying to break out. Gold is setting up for a potential breakout from a multi-year base. Bitcoin and anything crypto-related has been in a steep uptrend. 

I have to point out that it’s not just milk and honey, roses and butterflies in the current tape. In the past couple of weeks, we finally saw some stocks selling off after strong earnings reports and weak guidance – SNOW, PANW. This is something to keep an eye on if it expands into more stocks because it could be a sign of a topping behavior. It only comes to remind us that bull markets tend to be low-correlation markets of stocks, where most stocks go up and not all of them. As the saying goes, stocks tend to top individually and bottom as a group.

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