A Time for Discipline
Rebecca Byrne, a writer for TheStreet.com, recently wrote an article called “The Arrival of Rotation?” With the stock market still searching for an overriding theme, market rotation is timely issue, and it might remain a popular topic of discussion for a good part of 2004.
What is market rotation? Market rotation is the process whereby overall market leadership “rotates” between different sectors or stock groups. For example, over the last few weeks we have witnessed a leadership change as the market has taken on a more defensive tone. The technology sector, one of the best performing sectors in 2003 has under performed consumer staples over this relatively short period of time.
How long does market rotation last?... That is one of the most important questions that portfolio managers routinely ponder. In this recent circumstance, is the setback a temporary pause for tech stocks or the beginning of an extended period of poor performance? In my view, answering these questions requires an accurate understanding of the balance between market expectations and economic reality. Technology stocks, maybe more so than any other sector, are constantly driven by the emotional extremes of excessive optimism and near-paranoid pessimism. As a result, expectations and reality are rarely in balance. Ultimately, the discipline to avoid these emotional gyrations is often what determines investment success.
Understanding the imbalance between expectations and reality requires a broad analytical approach. In fact, some times the best way to evaluate the emotional climate driving tech stocks is to study how other sectors of the market are acting. Analyzing the trading momentum in sectors like health care and consumer staples can provide insight into what might occur in other sectors like technology. In a sense, some times the best way to pick a sector or even an individual stock is to first consider the alternatives.
Back to the question of time… Some market environments are characterized by frequent leadership rotation, while others ride the same leader for an extended period of time. The technology stock boom during the late 1990’s was an example of the latter. As we look ahead, the absence of a secular driving force like the Internet makes it doubtful that any one sector will lead the market for a sustained period. Investment environments characterized by frequent leadership changes are inherently more difficult. Most investors who try to time the sector rotations end up a day late and a dollar short because they allow emotions to overwhelm investment discipline.
At the end of the day there is an alternative approach… For 2004, it may be prudent to avoid the market rotation rollercoaster and concentrate on identifying quality companies that will deliver above average earnings growth in the context of reasonable expectations. This approach will require diligent fundamental analysis, as well as the discipline to stick with quality companies despite short-term volatility resulting from market rotation. There you have it. A time for discipline.