The big rotation taking place in the stock market explained

VIDEO3:0103:01
Value stocks are outperforming—here's why they're trending

The market is rotating. Value is back. Momentum is out. Cyclicals rule. Defensives are so August. No one wants low volatility.

What is it we are rotating out of, and what are we rotating into?

There's a lot of confusion about different ways to slice and dice the markets, and which stocks fall into which categories. For example, many momentum stocks this year (those that show price appreciation) have been defensive stocks like consumer staples, but not all momentum are consumer staples.

Confusing? Let's try to sort out some of the differences.

First, are there signs of rotation? Yes. Since bond yields bottomed at the end of last week, cyclical stocks — which tend to do better when the (global) economy is improving — have outperformed:

Cyclical rally

(Since Wednesday's close)

Banks, up 7%

Transports, up 5%

Energy, up 6%

Retail, up 9%

At the same time, defensive stocks — stocks that are not as much tied to global growth, which have been strong most of the year, have begun underperforming:

Defensives lagging

(Since Wednesday's close)

Consumer Staples, down 1%

REITs, down 2%

Utilities, down 2%

Much of the reason for the rotation is over optimism on trade talks, the primary driver of the stock market this year.

Let's sort out some of the ways the markets get sliced and diced.

Cyclicals vs. Defensive

Cyclical stocks are those tied to the economic cycle. When growth is increasing, cyclicals' profits and stock prices tend to rise, and vice versa. Classic cyclical sectors include semiconductors and most technology stocks, transports, energy and materials. Some consumer-related sectors like automotive, gaming, and restaurants are also considered cyclical.

Cyclicals have lagged most of the year on concerns global growth is slowing.

Defensive stocks are generally tied to sectors that are not tied to the economy improving. Their revenues are considered stable, and so generally are earnings. Classic defensive sectors are utilities, health care and consumer staples. The theory behind defensive stocks as a broad equity class is that people will always buy electricity and toothpaste and go to the dentist.

Defensive stocks have generally been strong this year.

Low Volatility versus High Beta

Low volatility stocks are stocks that do not normally fluctuate in price dramatically from the benchmark indices. One way to measure volatility is to use beta, which is the amount a stock in the S&P 500 price will deviate from the S&P on any given day. The S&P is given a beta value of 1.0. If a stock has a beta of 1.5, it means that on a typical day, if the S&P is up 1.0%, that stock will be up 1.5%.

Low volatility stocks are often associated with defensive sectors like utilities, health care, and consumer staples, and that is a good rule of thumb but not invariably true.

Coca-Cola is a classic low-volatility stock; it has a beta of 0.4, meaning that on a day when the S&P 500 might be up 1.0%, it would typically be up 0.4%.

Because defensive sectors have been strong this year, low-volatility has been a popular strategy and there are several large ETFs in this space. The Invesco S&P 500 Low Volatility ETF (SPLV) selects about 100 S&P 500 stocks with the lowest daily volatility over the past year, without regard to sector. It rebalances quarterly. It's heavily weighted in financials and utilities like Duke Energy, Eversource, and Exelon.

Its larger competitor, iShares Edge MSCI Min Vol U.S.A. ETF (USMV), is a bit different: it has more stocks (about 200), and applies constraints on how large the sectors can get. There is a much lower weighting to both Financials and Utilities, and includes Visa (fintech), Coca-Cola and Pepsi (consumer staples).

High beta stocks are the opposite: they move more than the market moves. This is a bet on volatility: On days when the market is up, these stocks should be up even more, and vice-versa.

The Invesco S&P 500 High Beta ETF (SPHB) tracks the 100 highest beta stocks in the S&P 500, but weights them based on those betas. Large holdings here are mostly semiconductors like NVIDIA, Micron, and AMD, but also Twitter and Amazon.

Growth versus Value

This is one of the oldest ways to pick stocks, and one of the most confusing. Generally, growth is associated with companies that are growing earnings, and value are associated with stocks that are underperforming and therefore considered "cheap."

This "folk mythology" about growth and value is true to an extent, but the ways these are sliced and diced are more subtle and can result in surprises.

Growth

The largest growth ETF, the iShares S&P 500 Growth ETF (IVW) selects stocks from the S&P 500 Index based on three factors: sales growth, earnings growth to price, and momentum. The largest holdings, not surprisingly, are the FANG names: Microsoft, Amazon, Facebook and Alphabet, but also includes fintech (Mastercard, Visa), as well as some consumer names (Merck).

When growth has been popular, as it has for several years, Growth tends to be synonymous with Momentum. But not in this rotation!

Notice one name missing from growth? Apple.

Value

Value is traditionally associated with stocks that might be underpriced. How to determine that? It's not just about low prices. For example, the iShares S&P 500 Value ETF (IVE) uses the S&P Value Index and picks stocks based on three factors: book value to price, earnings to price, and sales to price. Generally, when these factors are toward the lower end, they are considered Value.

The largest holding in the' IVE' may surprise you: Apple(!), followed by JPMorgan, AT&T, Bank of American, and Chevron. No surprise that underperforming Financials and Energy stocks are represented, but Apple as a Value stock?

Momentum

This is, arguably, the broadest category of all. Momentum stocks are stocks that are showing price appreciation above a benchmark index. It can include almost anything above: growth or value stocks, low volatility or high volatility, defensive or cyclicals.

These stocks are usually strong when the market is going up, but in a sudden selloff they will typically drop more than the market. This is what has happened in the last few days: momentum names like Paypal and Mastercard (fintech) and consumer names like Merck and Kimberly Clark that have been strong all year have been weaker.

Momentum names

(Since last Wednesday)

Paypal, down 6%

Mastercard, down 5%

Merck down, 6%

Kimberly Clark, down 8%

The iShares Momentum Factor ETF (MTUM) selects large- and midcap equities based on price appreciation over a 6- and 12-month periods, but that also exhibit low volatility over the past 3 years.

The largest holdings in MTUM include Mastercard and Visa (Financials, which are cyclicals) as well as Procter & Gamble (Consumer Staples, which are defensive), and Microsoft and Cisco (Technology, which are also cyclicals).

What constitutes Momentum can change depending on the time periods involved, and even over what kind of rules are involved. A competing ETF, Invesco DWA Momentum ETF (PDP), also claims to pick momentum stocks but uses a proprietary system that emphasizes midcap stocks. The largest holdings include large cap stocks like Apple and Mastercard but also American Tower, O'Reilly Automotive, and Domino's Pizza.

What does this all mean?

All of these strategies involve slicing and dicing the market into different segments. You can buy stuff on momentum, on low Volatility, on Growth, or a bet on an economic recovery (Cyclicals). These ways of slicing and dicing the markets are called "factors" but since the advent of ETFs financial advisors have created a new term for them: "smart beta."

Just trying to sort through all the options -- and figuring out where the market is going, even if short-term -- is now the fundamental challenge for investors.

It all boils down to lots of opportunities to make money, but also lots of confusion on what's right to own.

"They generally do exactly what they say they're going to do, but that doesn't necessarily mean they do what you expect them to do," Dave Nadig from ETF.com explained. "Once you're outside traditional approaches, the burden of knowing-what-you-own becomes even more complex, and much more important."