Option Activity Signals Early Rotation Into Defensive Sectors

Over the past few trading sessions, option activity has been picking up in defensive sectors and maybe signaling an early rotation. The concept of sector rotation is that the market will allocate capital in the area that is likely to outperform. If noncyclical parts of the market are starting to gain relative strength, it’s an indication of diminished expectations. As the market is testing new highs, this type of rotation could be a hint at the bullish fever beginning to break.

Sector Rotation in the New Age Economy

One of the most significant parts of top-down analysis is attempting to identify sector rotation. Many books that discuss sector rotation do so from a grand rotation over the course of the economic cycle. However, the point of monetary policy is to eliminate the business cycle. If you’ve been following the Federal Reserve machinations over the past 20 years, the measures taken have been escalating. Is this a “new economy” where cycles are gone, or is it similar to the new economy being pushed before the tech bubble?

While monetary stimulus measures have made the grand rotation from recession to expansion difficult to see, the rotation amongst the sectors in the intermediate term is still in effect. While the indications are developing, the recent performance of the Utilities sector and the recent option activity is starting to reveal the age of the rally since last March.

The strength in utilities is particularly interesting given the fact the 10-year Treasury yield has been rising (see chart below). Typically, a rising 10-year yield is negative for Utilities because of the focus on utility companies for their yield. At a minimum, it would indicate that they would be one of the worst performers instead of falling in the middle of the pack.

Sector Rotation Option Activity

 When identifying sector rotation, it can’t be one company showing strength or weakness, there needs to be a pattern. That means there needs to be some strength in the respective sector and a number of stocks moving in unison.

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