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The Pros And Cons Of The Federal Interest Rate Hike

The Pros And Cons Of The Federal Interest Rate Hike

The United States Federal Reserve…

Stocks Pull Back Following Interest Rate Hike

Stocks Pull Back Following Interest Rate Hike

Fed's interest rate hike drove…

Clif Droke

Clif Droke

Clif Droke is the editor of the two times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock…

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Sector Rotation versus Internal Rotation

In recent years you may have noticed that at certain times of general stock market weakness, certain high-profile individual stocks will suddenly decline by as much as 20-40% in a single day or week. Meanwhile, the broad market (or stock sector in question) remains relatively buoyant and then eventually continues along to higher levels.

In fact, this is a trend that has been repeated several times in just the past two years alone. It's something I've taken notice of and have done some in-depth studying of and I believe I can outline some general principles on this phenomena that are useful to the individual trader or investor.

In times past, a dominant cycle bottom (for instance, the 40-week cycle) was often characterized by weakness across the broad market and manifested by the major indices such as the Dow 30 index declining substantially before the cycle finally bottomed and the market trend reversed. But in recent years there are times during periods of cycle-related weakness, rather than the entire market taking a major hit, the weakness has sometimes been narrowly focused into a small number of individual stock issues.

I've noted this increasing use of high-profile and important individual stocks - in both the NYSE and the NASDAQ - for purposes of internal corrections at pivotal cycle bottoms. This was seen, for instance, at the 60-week cycle bottom earlier this summer and also at last year's 10-year cycle bottom. In other words, for instance, rather than letting the Dow 30 Industrial index take a hit at a major cycle bottom (such as the 10-year cycle bottom last October, which incidentally coincided with the 40-week cycle bottom), the market makers apparently forced most of the cycle-related weakness into a small handful of individual stocks. To them, it seems, this is preferable to spreading the weakness out among all the individual components of a market index. This concept is similar to sector rotation, only we might call it "internal rotation."

A case in point would be the Dow 30 component Merck & Co. (MRK) in October 2004. Merck took a huge hit in October '04, falling over 40% as the 10-year cycle was descending at that time. But notice how well the Dow 30 Industrial index held up by comparison. The Dow fell to the 9800 area, which was a triple-bottom low that had earlier been tested in May and August of that year. But Merck fell to a level that hadn't been seen in almost nine years. Merck took it on the chin so that the Dow Industrial index, on balance, wouldn't have to.

More recently there is the example of Amazon.com (AMZN), which took a sharp dive in late October as another short-term cycle was bottoming. By having AMZN and a couple of other well-known tech shares take the hit (falling to lower lows), the NASDAQ Composite index was able to ride out the rough spot with a relatively shallow pullback (making a higher low in the process) and was well positioned to launch another rally leg.

The practice of "internal rotation" is also applied on certain occasions to other stock sectors besides the techs and industrials. For instance, even the market for gold and silver shares has been the subject of an internal rotation campaign in the recent past. Take, for instance, the period of late October/early November 2003. During that time of heightened downward pressure from a bottoming short-term gold stock cycle, the XAU gold/silver index was under some of that pressure to a degree in the fall of that year. But notice what happened during the late October of 2003 when an XAU component, Agnico-Eagle (AEM), took an abnormally large hit before finding bottom in November. Here is an example of an individual gold stock "sacrificed" for the purpose of keeping the overall sector buoyant.

Although it can sometimes happen that buoyant individual stocks fall victim to internal rotation campaigns, more often than not, shares that have already been weakened by heavy overhead supply and are in downtrends are the ones that are selected by insiders for the sacrificial hit so that the broad market can remain healthy. An analogy can be drawn in this modern practice to certain ancient pagan tribes who sometimes sacrificed the sick and elderly among them to their tribal gods in order to (in their minds) pacify those gods and keep the remainder of the tribe strong and healthy.

Sector rotation of course is the practice of shifting money - and the focus of the investing public - into select stock market or industry sectors. The goal of sector rotation is to keep rotating investment funds into the strongest performing sectors of the market until the given sector fails to outperform the broad market. Then another shift is made into another sector in what might be comparable to a game of musical chairs. This practice in recent years has become a favorite practice of both professionals and the public.

But the focus here is on the important discovery on the part of the insiders (namely, internal rotation), which allows them to manipulate the market by keeping it more buoyant than it otherwise would be at or near the "hard down" phase of a major trading cycle. We've seen evidence of the crude beginnings of this manipulative practice as far back as the 1997 mini-panic, although at that time the practice hadn't been honed to perfection as it is now. Truly, the insiders have learned many important lessons from the past 20 years of stock market history alone.

The lesson that can be drawn from the practice of internal rotation is that whenever the investor sees certain well-known, actively traded and, in many instances, leading individual stocks experiencing abnormally large declines while the major indices they are represented by hold up fairly well, it usually means the correction phase for the broad market won't be quite so dramatic. Once the weakness has been corrected the indices will generally be in a technical position to continue higher once the correction phase is over.

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