Interestingly—and perhaps not surprisingly—sector rotation strategies have not been widely embraced by most retail investors, and even recently, with the advent of an almost unlimited number of Exchange Traded Funds, sector rotation is still not a widely employed trading strategy.
There’s Always a Bull Market Somewhere
“There’s always a bull market somewhere” is a well worn but very true aphorism. No matter what “the market” is doing, up, down, or sideways, there really is always a bull market somewhere and sector rotation trading strategies are designed to find and exploit these “mini-bull” or “stealth” bull markets.
It’s a lot easier task during bull market years when the major indexes and subsectors are all in upswings. During these periods the challenge is to make more money than the averages by focusing on the strongest sectors, and there are well-defined ways to do this.
It’s a little tougher to “beat the market” during bear market years because many subsectors are also in decline along with the general indexes, but surprisingly, one can even profit in bear market years because subsectors that are rising can always be found.
On top of that possibility is the new opportunity provided by the inverse Exchange Traded Funds that let you make money as the underlying index or sector declines. As we discussed earlier, these ETFs increase in value as the underlying index declines and so, effectively, you’re turning a bear market into a bull by “shorting” with an inverse Exchange Traded Fund.
Even during the dark years of 2008 when most investors took double digit losses approaching or even exceeding -50 percent, there were sectors producing profits for investors who could identify their performance. With a major meltdown like 2008, the best opportunities are usually found on the “short” side of the market, naturally, and several Exchange Traded Funds offered the opportunity to profit from the decline.
Here are examples of specific results during 2008 and why sector rotation can supercharge your portfolio:
PSQ: Short QQQ ProShares: +51.5 percent
SH: Short S&P 500 ProShares +37.5 percent
DOG: Short Dow 30 ProShares: +29.8 percent
But other asset classes could have provided shelter, as well:
TLT: Barclay’s 20 Year Bond Fund: +28.3 percent
FXY: Currency Shares Japanese Yen Trust: +22.9 percent
GLD: SPDR Gold Trust: +4.9 percent
UUP: PowerShares Bullish Dollar Index: +4.2 percent
In 2009, the big story was the explosive rally that began in March. Through mid-November, 2009, the S&P 500 was up +21 percent but even more impressive gains were achieved in sectors like Brazil, which gained +114 percent, Vietnam +68 percent, Emerging Markets Index +64 percent, and Silver gaining +53 percent.
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 shorted the market during the downtown and 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. It is important to note that past performance is no guarantee of future results.
However, these kinds of potential returns are why institutional money has gravitated toward sector rotation; there isn’t just “one market” but rather a wide variety of “sub-markets,” some of which will always be in significant uptrends and outperforming the general indexes. Sector rotation trading strategies may allow the investor to identify and profit from sectors that are outperforming the general market.
Nine Basic Sectors
Figure 1: Sector Rotation Model
Most discussions of sector rotation focus on the nine industry sectors tracked by the Select Sector SPDR Series of Exchange Traded Funds that cover the basic industry groups in the S&P 500.
1. Technology (XLK)
2. Industrials (XLI)
3. Consumer Discretionary (XLY)
4. Materials (XLB)
5. Energy (XLE)
6. Consumer Staples (XLP)
7. Health Care (XLV)
8. Utilities (XLU)
9. Financial (XLF)
These nine sectors are represented by their corresponding Exchange Traded Funds (symbols in parentheses) and are highly liquid and actively traded issues. In Figure 1 you see the sector rotation model that matches up the sectors with the corresponding economic cycle.
So the theory is pretty simple: figure out which stage of the economic cycle you’re in and then buy those sectors that are typically the leaders during that phase.
In following this theory, looking at Figure 1 and starting from the left with full recession, one could choose to focus on Technology and Cyclical, and, in fact, those two sectors have performed much more powerfully as The Great Recession draws to a close.
Then in the early recovery stage one could switch to Industrials and Energy and, as 2010 draws to a close, there is substantial strength in both of those areas. And as the recovery continues, a good sector rotation plan might be to switch to Staples, Services, and then finally Utilities and Finance as the next recession and bear market begin.
Will This Time Be Different?
The theory of sector rotation works well in a normal business cycle. However everyone would agree that The Great Recession was anything but a normal business cycle recession and so it would make sense that the recovery might also differ from “normal” and so sector rotation might be different as well.
There are several reasons for this. First of all, we have experienced unprecedented levels of government intervention into all corners of the American free enterprise system. Furthermore, unlike other recessions, we have seen the consumer, who comprises 70 percent of the U.S. economy, take enormous hits to his net worth and sense of security through the popping of the stock market bubble, the housing bubble, and the severe contraction of credit that has taken place. It appears that consumer spending might have been changed forever and if that’s the case, then the American economy might also very well be changed forever.
Looking at individual sectors, we see that the Industrial Sector has undergone substantial change with the bankruptcies of Chrysler and General Motors and the government’s involvement in those businesses along with the outsourcing of enormous manufacturing capacity to foreign countries.
The Energy Sector has been impacted by the wild fluctuations in the price of oil and here, too, we see the hand of government reaching in with talk of green energy, carbon tax credits, and climate change initiatives.
Consumer Staples is perhaps the only sector not likely to see major changes as people will still need to buy food and toilet paper and clothes, but even here we will see a shifting away from “wants” and more towards “needs” as consumers deleverage and downshift their expectations in the new world that lies ahead.
Health Care is about to undergo a dramatic change with health care reforms, and as the baby boom ages and puts increasing demands on this system, the face of health care is likely to undergo dramatic and permanent alteration.
Utilities are quite likely going to shift from being a defensive play to being a growth play as the country is in desperate need to upgrade and modernize its power grid. Emission standards for factories and utilities are likely to add costs and change the nature of this business as well.
And finally, the Financial Sector is a mere shadow of its former self and a totally transformed entity. Companies that have been around since the dawn of time have disappeared and the “too big to fail” group has consolidated power in a way not seen in decades. Government regulation is sweeping through this sector from executive compensation to new regulations to prevent another meltdown like the 2007–2008 calamities, and bank failures will continue for years as bad credit defaults and commercial real estate loans and credit card and residential loans are written off.
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.