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Active investment strategies: Sector rotational strategies

  • Wiley Global Finance WILEY GLOBAL FINANCE
  • Exchange-Traded Funds
  • Sectors
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The traditional view of sector rotation confines itself to the nine major sectors on the S&P 500 but this interpretation is no longer accurate or even valid. The world has become a much bigger place, so to speak, and today investors have an almost unlimited number of sectors available in which to gain exposure.

Today Exchange Traded Funds offer exposure to the traditional sectors as well as all sorts of new things like Precious Metals, International, Developing Markets, Currencies, and Commodities. The top performing sectors for 2008 and 2009 had little or nothing to do with the standard nine sectors usually considered by the science of sector rotation.

The Velocity of Money and the Incredible Disappearing Investor

Ever since the violence of the bear market in 2008 and subsequent explosive rally of 2009, the very nature of the U.S. stock markets seems to have changed. Volumes are dramatically lower than before the bear hit and it appears that many retail investors have fled the equities markets for the perceived safety of the bond market. This absence of a multitude of small investors has not only led to lower volumes but also to dramatic increases in volatility.

Market moves that used to take years to unfold now happen in months, months are compressed into days, and days into single sessions. The frequency of 1 percent or greater moves on the major indexes is at levels unseen since the Great Depression and at the time of this writing, shows no sign of letting up.

Today the New York Stock Exchange looks more and more like a commodity pit or foreign exchange market where big players can move the market seemingly at will, and increasingly it feels more like a gambling casino than a bona fide stock exchange where shares are traded based on inherent value or at least the perceived value of the underlying companies.

Also contributing to the volatility is the speed at which information travels around the world, the power and speed of the super computers running the big trading desks, and the ease of buying and selling equities and ETFs with the push of a button on your laptop or smartphone.

All of this makes for a more competitive environment and investors and traders have to adapt or be left behind.

Let’s take a look at the nature of sector rotation in this new environment and at how much things have changed and how fast things are moving. We’ll start our exploration by taking a look at Figure 1 and the ETF that tracks the oil market, the United States Oil Fund.

Taking a look at the United States Oil Fund (USO), we can see approximately a +60 percent positive move during the first half of 2008, followed by approximately a -80 percent drop through March 2009, only to be reversed to a +60 percent gain over the first 11 months of 2009.

The chart of USO in Figure 1 clearly demonstrates the speed and velocity of money moving in and out of this market over a very compressed time period. This velocity and volatility offer enormous opportunity for agile traders but also enormous dangers for buy and hold investors or less agile traders.

Figure 2 shows us a view of FXI, the iShares FTSE/Xinhua China 25 Index over the same period of time. The same type of violent price action is evident as money moved into and out of this market at a pace that surpasses anything we’ve seen in recent history. Figure 3 is a picture of GLD, the SPDR Gold Trust and it, too, shows the same kind of volatility and rapid fire changes of direction.

And in the chart in Figure 4, we see the movements of “conservative” bond fund, the 20-Year Treasury. In traditional sector rotation philosophy, certain sectors are supposed to lead the way out of recession and one of these is Industrials, as depicted in Figure 5.

Another perennial leader during economic recoveries is Technology and in Figure 6 we can see how it has performed during the early days of recovery from The Great Recession, bouncing off the March lows and blasting steadily higher through the end of the year.

FIGURE 1: United States Oil Fund (USO)

26b_Fig1

Chart courtesy of StockCharts.com

As you would correctly expect, we’ve seen significant gains in these sectors with Technology gaining approximately +70 percent from its lows and Industrials climbing +80 percent from its lows.

Two late cycle sectors are Utilities and Financials and these usually don’t come to life until later in a recovery, but here we see how they have fared in the early going. Figure 7 shows us how Financials have done, which is particularly interesting, since the Financial Sector has been one of the most heavily influenced by government actions in its panic to save institutions that have been deemed “too big to fail.”

Figure 2: FXI: iShares FTSE/Xinhua China 25 Index

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Chart courtesy of StockCharts.com

Supposedly a lagging sector, the Financial Sector is up an impressive +147 percent from its lows at the depths of the bear market. In Figure 8 we see a graphic picture of the supposedly stodgy Utility Sector and even this haven for widows and orphans has added an impressive +26 percent over the course of less than one year’s market action.

Likewise, taking a look at Energy in Figure 9, this mid-cycle leader in normal times has logged better than +50 percent gains.

FIGURE 3: Gold 2008–2009

26_Fig3

Chart courtesy of StockCharts.com

Not to mention Gold’s impressive performance of more than + 50 percent depicted in Figure 10.

Looking outside the traditional nine sectors we see many examples of even more stellar returns, like Brazil gaining more than +120 percent from its March Lows in Figure 11.

When you look at all of these charts put together, one thing becomes very clear; they all look remarkably alike. Just as nearly all asset classes were compressed and moved as one during the bear market, they have all become compressed and have been moving close to being one during the subsequent recovery.

Obviously, such returns are highly unusual and due to the very specific financial crash of 2008, the market downturn that quickly followed, and then the upturn that took place right after. Those who were long during the uptown found strong returns, but it is important to note that this is very event-specific and not something easily replicable in the future.

So traditional sector rotation philosophy has—for the time being, at least—been overridden by the Federal Reserve and the enormous liquidity coursing through the market. Instead of a smooth cycle of leadership change and outperformance, all sectors are barreling ahead at the same time.

A quick glance at the S&P 500 chart tells us one more interesting thing in Figure 12.

Its rise looks a lot like the other charts but with a significant difference. It’s up an impressive +21 percent over this same time period but this just puts it in the “stodgy” class of Utilities and makes it a comparative underperformer to almost every sector available to investors today.

FIGURE 4: iShares 20-Year Treasury Bond (TLT)

26_Fig4

Chart courtesy of StockCharts.com

FIGURE 5: Industrials Select Sector SPDR

26_Fig5

Chart courtesy of StockCharts.com

FIGURE 6: Technology Select Sector SPDR

26_Fig6

Chart courtesy of StockCharts.com

FIGURE 7: Financials Select SPDR

26_Fig7

Chart courtesy of StockCharts.com

FIGURE 8: Utilities Select Sector SPDR

26_Fig8

Chart courtesy of StockCharts.com

FIGURE 9: Energy Select Sector SPDR

26_Fig9

Chart courtesy of StockCharts.com

FIGURE 10: Gold (GLD)

26_Fig10

Chart courtesy of StockCharts.com

FIGURE 11: Brazil Index

26_Fig11

Chart courtesy of StockCharts.com

FIGURE 12: S&P 500

26_Fig12

Chart courtesy of StockCharts.com

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Article copyright 2011 by John Nyaradi. Reprinted and adapted from Super Sectors: How to Outsmart the Market Using Sector Rotation and ETFs with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint.
The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.

Commodity ETPs are generally more volatile than broad-based ETFs and can be affected by increased volatility of commodities prices or indexes as well as changes in supply and demand relationships, interest rates, monetary and other governmental policies or factors affecting a particular sector or commodity. ETPs that track a single sector or commodity may exhibit even greater volatility. Commodity ETPs which use futures, options or other derivative instruments may involve still greater risk, and performance can deviate significantly from the spot price performance of the referenced commodity, particularly over longer holding periods.

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