Unless you follow technical analysis closely, you may be blissfully unaware of all the banter regarding the lack of market breadth and the narrowing leadership out of a small group of stocks…

Specifically large-cap growth stocks – and more specifically tech stocks.

The issue around participation or breadth is an important topic worth understanding.

The crux of the topic is this: 

Healthy markets have strong participation from stocks – lots of stocks – in many different sectors. Conversely, weak markets tend to see very narrow leadership from a small group of stocks, often in just one or two sectors.

And that’s been the endless debate in 2023.

But there might be something else at work here that isn’t getting enough attention… that sectors are following a classic pattern of recovery seen many times before.

I’m talking about the relationship between economic cycles and market cycles.

We know the economy moves between cycles of expansion, peaks, contractions, and troughs, like this.

The business cycle also influences the rotation of stock market sectors and industry groups. 

Certain sectors perform better than others during specific phases of the business cycle. 

Knowing the stage of the business cycle can help investors position themselves in the right sectors and avoid the wrong ones.

The graph below shows the economic cycle in blue and the stock market cycle in red with the best-performing sectors in green at the top.

The blue economic cycle corresponds to the business cycle. The centerline marks the contraction/expansion threshold for the economy. 

Notice how the red market cycle leads the business cycle. The market turns up and crosses the centerline before the economic cycle turns in anticipation of future change.

Similarly, the market turns down and crosses below the centerline ahead of the economic cycle. 

With this change comes a change in sector performance as investors rotate from growth sectors to the more defensive value sectors in anticipation of the economic slowdown.

As markets bottom investors tend to rotate again, but this time back to the more growthy sectors of the market.

Technology and Communications are the first to turn up in anticipation of a bottom in the economy with Consumer Discretionary stocks not far behind. 

These are the sectors that we’d expect to be the leaders at the beginning of a bull run in the stock market.

And here they are – following a very classic pattern. 

Using the sector SPDR ETFs as our sector proxies XLK (Tech) is +32% YTD, XLC (Communications) has posted a +30% YTD performance, while XLY (Cons Disc) has gained +17.75%.

The strongest sectors on a relative basis right now are Technology, Industrials, Consumer Discretionaries, and Basic Materials.

So this begs the question…

Is what we’re seeing out of Technology, Communications, and Discretionaries a case of narrow sector leadership or a case of markets doing what they’re supposed to do?

Stay tuned for more as the markets unfold.