Industry Sector Preferences in a Rising Interest Rate Environment  (4/22/05)

by Richard W. Miller, Ph.D.

       (appeared in January '05 issue of CANSLIM.net News)

Several important cycles impact the market.  The reasons, for the most part, are well understood:  the six-month cycle reflects periods where money traditionally enters an active market versus periods that capture the summer doldrums.  From May 1, 1950 through April 30, 2004, if one had invested $10,000 in each of two six-month periods (a bullish November 1 through April 30 and a bearish May 1 through October 31) and kept each in the Dow for just those six months, the first would have grown to $491,623 (+4,816 percent) while the second would have fallen to $9,684 (-3.2 percent).  November brings with it that extra confidence to go long. 

 The second cycle of significance is the four-year Presidential cycle.  From 1940 through 2004, the pre-election year (2003 most recently) has averaged returning +18.1 percent for the S&P 500 and offered positive returns 16 of 16 times.  The second-best performer, the election year, has averaged returning +7.5 percent and offered positive returns only 12 of 17 times.  Obviously, the party in power does everything it can to influence the economy and win the election.  In this last one, for instance, the Fed increased the money supply dramatically to boost the economy (and in the process further weakened the dollar).  Both cycles were discussed in the November 2003 issue of CANSLIM.net News.

 The third cycle, as I reported in the December 2004 issue of CANSLIM.net News, is the decennial cycle where the fifth year of each decade since the 1880s has offered a significantly greater return than other years (averaging +30.8 percent for the Dow).   Significantly too, the lows of the fifth year occur most often in late January.  Unlike the other two cycles, this one is not well understood, though I suspect it arises because of a confluence of the first two cycles with business cycles that work their way through the economy.

 It’s well known that the stock market is a leading indicator for such business cycles, i.e., the cyclic ups and downs in the U.S. GDP.  Unfortunately, the business cycle itself is not exactly defined in its length, in its intensity, or in its degree of sector participation; consequently, it’s usually identified well after the fact.   The accompanying chart shows a typical relationship among the business and market cycles and the business sector involvement.  It further shows where the Fed usually starts tightening rates.  As the economy begins its recovery, for example, the transportation sector profits from increased business activity, while at the other extreme in a hot economy, the Fed looks to tighten and defensive sectors, like health care and utilities, outperform.  Read Perter Navarro’s “If It’s Raining in Brazil, Buy Strarbucks,” for more detail on these relationships.  Note:  The chart was developed from his work.

Making the assumption that the Fed’s involvement provides a landmark for the business and market cycles, consider how 31 industry groups (members of the 10 larger sectors) have performed following the Fed’s first rate increase.  During the last two decades, the Fed has undergone a cycle of tightening three times:  7 increases from a 3.0 to 6.0 percent funds rate over a 12 month period beginning in February 1994; 6 increases from a 4.75 to 6.5 percent funds rate over a 11 month period beginning in June 1999; so far, 5 increases from a 1.0 to 2.25 percent funds rate over a 6 month period beginning in June of 2004.  The table shows how each of these industry groups has performed over these three periods.  The 3-, 6-, and 9-month rankings are provided for these three cycles of tightening (the 9^th month for the ’04 cycle will occur in March ’05).  The ’94 and ’99 rankings were averaged, then that average ranked, as well.  The best (1-6) and worst (25-31) rankings are highlighted.  It’s obvious that the most recent cycle differs somewhat from the earlier two which are remarkably consistent with one another, e.g., the internet was rapidly growing in the last decade, and it maintained its leadership through the 9 months shown, but in the most recent cycle it has performed poorly.  Energy, on the other hand, performed well over the first 6 months for all three cycles, but fell off in the 9^th month.  Real estate is another that performed differently:  worse in the earlier cycles when interest rates were not as favorable. 

This analysis may be predictive of the group rotation to occur over the next few months, drugs and health care, for example, should improve, but bear in mind that this last tightening cycle began from a far lower Fed rate.  As a result, it may not been initiated from normal business cycle considerations.