Cramer: How We Got Into This Rotation

Do we trust a vicious rotation? Do we want to buy into a market that suddenly has eyes only for the big international industrials and the financials?

The answer?

We have no choice.

This market is all about rotations and has been about rotations for as long as there has been a paucity of money coming in and as long as ETFs have dominated trading.

So when a company like a Caterpillar (CAT) or a 3M (MMM) has a magnificent earnings report, we do not question the report; we accept that things have gotten better in the world, and if things have gotten better in the world then we have no use for the stock of Johnson & Johnson (JNJ) or Eli Lilly (LLY) -- no matter how good they are. We need to throw the drugs away and buy the industrials because there isn't capital coming in to make it so we don't have to throw away something to buy something else, and we have ready-made instruments to profit off the lack of money coming in.

You can buy a cyclical ETF and you can sell a healthcare ETF. You can buy an ETF for the banks and knock down an ETF for consumer products.

Everything's set up to compound the rotation, and that's just what's happening.

Why is it like this?

Let me recount how we got to this point, where the stock of a 3M or a Caterpillar could be up so big on good numbers and a Johnson & Johnson or Eli Lilly could be down so big on good numbers.

First, let's stipulate that the world is a far stronger place than it was a year ago. We have global growth popping up everywhere, which is why the stocks of a Honeywell (HON) or an Illinois Tool Works (ITW) or a Cummins (CMI) or a Caterpillar can fly high here. The costs have come out of these companies. Their roles are lean. Their managements have been waiting for the time when things are getting better, and here it is. They are embracing the reality of really good sales growth, not just earnings growth. The top line is strong, which means the bottom line is like lightning.

That's how you get the classic beat and raise. But that's only one part of the equation of today's trading.

Second, unlike the fast-growing tech companies that often pay their workers in stock and cash, these firms constantly buy back their stocks. That means on any given day there isn't a lot of stock for sale. When you compound that with the idea that we are really dealing with companies that are just at the beginning of a turn, you know there is the equivalent of a stock shortage in these companies. I know that sounds silly, but big investors who want to buy 500,000 shares of 3M today are struggling to do so. Sure, you can buy all the General Electric (GE) you want, but then again these portfolio managers are looking for the stocks of companies that are going to have positive year-over-year numbers and that may not be possible at GE. Trust me when I say that a large portfolio manager, someone who runs, say, $5 billion, needs to buy a lot of 3M to make it matter. When you add another couple of managers trying to buy the same stock, there's just not a lot of supply, and that's how the stock flies so high.

Or to put it another way, 3M bought so much stock over the last few years that there's not enough at any given moment to go around, and today there's a bunch of funds fighting over very few shares. Who the heck wants to sell this stock after those numbers?

Second component? When we get to this stage in the economy, when it is genuinely accelerating, we have to start measuring the size of the beat. Portfolio managers are always looking for the stocks of companies that are going to surprise to the upside. The size of that upside is what's most important.

We know, for example, that a company like Clorox (CLX) is doing well and will keep doing well because it is run really terrifically. We know that a PepsiCo (PEP) will report a fantastic number because that's what it does. Better than expected. These are consistent companies.

But there comes a time when managers are attracted to a different kind of earnings beat, one that is shocking both top and bottom. They want magnitude. As fantastic as PepsiCo CEO Indra Nooyi is, and she is the best, it's really difficult for her to suddenly put up shockingly fabulous numbers. But if you are 3M or Caterpillar and you run lean and you have new products and low inventories and you can raise prices and have spare capacity to meet demand, you can put up a relative beat that is so huge the stock is a magnet for money. If you are a portfolio manager and you see Stanley Black & Decker (SWK) showed an astounding 9% growth in tools, which is unheard of, you know you have to reach for the stock.

Third component? The inning. When you see the first good quarter, you know things aren't about to turn down. A worldwide expansion allows you to have several more beats just like this vs. the anemic numbers from the year before. We have seen early innings performance in construction, in road building. Amazingly, aerospace seems like it's still early, too.

Hence, why the demand is so fierce for the shares.

How about the banks? What's that all about? Interest rates move up when the economy is humming. That's a simple equation that drives the bank stocks so they all fly together, the good with the bad, in lockstep, ETF formation.

With any cyclical rotation, there are fringe players. What do we do with the techs? Very difficult. Some investors will glom on to them betting that they will have big beats, too. That's been the case, say, with Facebook FB and Microsoft (MSFT) of late. Some will buy them because the characteristics of the winning industrials -- worldwide growth, weaker dollar, robust sales -- can produce similar results. (Eli Lilly, Illinois Tool Works, General Electric, PepsiCo and Facebook are part of TheStreet's Action Alerts PLUS portfolio.) 

But let's not overthink this; anything that's not a big-time industrial or a bank can be a source of funds to buy the stocks of those two winning cohorts, especially if they don't crush the numbers.

Oh, and let me just put in a word for what's going on in Washington with these companies -- nothing. I talk to the CEOs of these companies and they have pretty much given up on anything coming from Washington. They only talk about it because I insist. They have nothing good to say. Worse, they are embarrassed by what's happening.

What's incredible about this rotation is we haven't seen a genuine acceleration in more than just China or the U.S. in ages. It's always been piecemeal. You have to go back to the '90s to get a worldwide move that's this powerful, and even then we didn't see these kinds of exaggerated moves. So just remember, what you are seeing is pretty historic -- our international companies, fueled by a weak dollar, by lean staffing, by fantastic managements strolling triumphant, all doing it for you, the owners. Here's to you Inge Thulin of 3M, Jim Umpleby of Caterpillar, and Jim Loree of Stanley Black & Decker. Take a bow. You deserve it. 

Join Jim Cramer, CNBC's Jon Najarian and Other Experts Saturday in New York

Jim Cramer will host CNBC's Jon Najarian, TD Ameritrade's JJ Kinahan, famed analytics expert Marc Chaikin and other market mavens on Oct. 28 in New York City to share successful strategies for active investors.

You can join them as they discuss how smart investors can make the most of options trading, futures contracts, fundamental and quantitative analysis and great ETFs to buy right now. Participants will also get a chance to meet Jim and other panelists and take photos.

When: Saturday, 8 a.m.-3 p.m. ET

Where: The Harvard Club of New York, 35 W. 44th St., New York, N.Y.

Cost: $250 per person.

Click here for the full conference agenda or to reserve your seat now. 

Action Alerts PLUS, which Cramer co-manages as a charitable trust, is long LLY, GE, ITW, FB and PEP.