The Boy Who Cried "Rotation"

“The Boy Who Cried Wolf” is a daily theme in financial markets. Media pundits sensationalize daily market move implications over and over again to a point where the public becomes numb. One of this year's victims has been the concept of rotation; we’ve heard about it all year, but it wasn’t until the past month that we truly had a reason to pay attention.

The Context of Concentration Risk

The concentration risk in the S&P 500 is real, with roughly a third of the index invested in technology stocks, while an equal-weighted approach offers much more diversified exposure. I’m not here to complain about it but simply to provide context on what it could mean if this rotation is indeed happening.

For active managers, it's a godsend. Diversification is a principle that many preach, and most firms enforce exposure limits. However, the technology concentration in the S&P 500 has made it challenging to outperform during periods of tech dominance. But if a true rotation occurs, active managers might finally have their moment to capitalize on their diversified strategies.

For passive investors, it’s a wakeup call. As rotation unfolds, their perceived diversification could prove to be less robust than expected. A shift out of technology could expose the vulnerabilities in a portfolio that leans too heavily on a single sector, despite being part of a broader index.

But how do we know when to listen to the Boy Who Cried Rotation and when to tune him out? The answer lies in the charts.

The example we’ll use to illustrate rotation is the comparison between RSP and SPY. An upward-sloping ratio between RSP and SPY implies broader market participation or, at the very least, technology underperformance, whereas a downward-sloping ratio indicates the continuation of tech dominance. Here’s a simple 3-step process I follow.

My 3 Step Bottoming Process

1.) Initiation - Physics 101

Initiation - In physics, overcoming inertia (the tendency of an object to remain at rest) requires the most energy. As a result, we want to see "hostile" action in the initiation stage, as it takes more energy to get going than it does to keep going—a basic theme in life: the hardest part is getting started. In this "rotation" narrative, we've seen several fakeouts this year where the media was crying rotation, but it quickly fizzled. Thrust need follow-through. Below, you'll see how the "rotation" narrative sparked several times this year with large single-day swings in the ratio. Savvy investors know that big upswings often come in strong downtrends, so patience is key. Once we get a 1-day trigger, we want to see it roll over to the 1-week mark before getting excited. Sprinkle in RSI (momentum) moving from oversold (22) to overbought (72) in 14 trading days, and my interest is piqued. This is also the first time in 2024 that the RSI has traded above 70. For those familiar with RSI ranges, this can indicate a "regime shift" in momentum from bearish to bullish. So far, so good.

Step 2 - Pull Back Response - Can they Take a Punch?

Pullback Response - Once we have the initiation, it’s only a matter of time before the trend gets punched in the mouth. As Mike Tyson famously said, “Everyone has a plan until they get punched in the mouth.” This is the most critical stage in the process—the initiation stage doesn't matter if it can't take a punch. This is where trends need to prove themselves and hold above key support, indicating that the bulls now have control. For this rotation theme, it checked all the boxes: price stayed above key horizontal levels along with the 50-day SMA (no magic here, just apply whatever moving average you use consistently), and RSI stayed in a bullish regime (above 40).

Step 3 - Craft The Pitch & Swing The Bat

Craft The Pitch & Swing The Bat - Once we have initiation, follow-through, the bulls show they can take a punch from the bears, and a confluence of support to manage risk against…it’s time to swing the bat. A pullback that doesn’t break below levels where the bulls would relinquish power to the bears presents a favorable risk-reward opportunity to initiate a trade. We are essentially betting the trend reversal is valid and using a recent low as our stop.

It’s Time

In a world full of sensationalism and the urgency to act, the key is being patient and having a well-defined plan to execute. It’s not just about identifying the start of a new trend but ensuring that the trend can survive the initial punches that inevitably come its way. The rotation theme seems to be in its early innings. For active managers, it’s time to earn your keep; for passive investors, it’s time to wake up.

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