Sector Rotation — Picking The Right Sectors

Sector rotation is an age-old strategy, probably older than any man alive today. But for a long time, it remains an institutional level strategy. Without sufficient resources, retail investors have little means to implement it. That is until the emergence of Exchange Traded Funds (ETFs). This innovation changed the landscape of investing and brought retail investors closer to the professionals. Well, in terms of access, at least …

What Are The Sectors?

The stock market can be broadly segregated into different business sectors. Each sector specializes in a designated area. For this purpose, the fund industry widely adopts the Global Industry Classification Standard (GICS) developed by MSIC and S&P. GICS assigns a specific sector, industry, and sub-industry to each company. And there are a total of 11 sectors: Consumer Staples, Consumer Discretionary, Energy, Healthcare, Financials, Industrials, Information Technology, Materials, Utilities, Communication Services, and Real Estate.

Sector Rotation — What Is It?

The concept is simple. Instead of trying to pick the right stocks, you try to pick the right sectors. The end goal is to achieve better performance than the broader market in the long run. If not, why even bother spending that effort?

Now, the stock sectors generally tread in the same direction. No surprises here. There is a reason why they all belong to an asset class called stocks. But having said that, their performance does vary under different circumstances. In a way, it is not that different from how individual stocks perform except that you are now dealing with diversified baskets of stocks.

As an example, in an economic downturn, people cut down their spending on luxury goods. There will be less dining out in posh restaurants or adding that next Hermes Birkin bag into your collection. So you can expect the Consumer Discretionary sector to take a hit. But, in the meantime, people will still need to shop for basic household goods and groceries. There is only this much we can cut back on the bare essentials. So the Consumer Staples sector will hold up relatively better.

Predicting Market Cycles

There are many ways to select sectors. Traditional approaches focus on predicting market cycles and then positioning the right sectors that thrive in that cycle. A rotation into these sectors tends to be held for a long period of time. So in a recession, you might see a shift of funds into more conservative sectors such as Consumer Staples and Utilities. Then when a bull market comes back on, the money will flow into Consumer Discretionary, Technology, Real Estate, etc. I made it kind of sound simple here. But in reality, it is extremely hard to forecast market cycles. Being too early or too late often has a big impact on performance. Then throw in the transaction costs involved for switching the sectors around, and you are probably better off with a buy and hold on a broad market ETF like SPY.

Momentum Based Measures

Another popular approach uses momentum based measures such as returns. Newton’s first law of motion seems applied everywhere.

“An object at rest stays at rest and an object in motion stays in motion with the same speed and in the same direction unless acted upon by an unbalanced force” — Newton’s first law of motion

It sounds valid except that it doesn’t help not knowing when and where that “unbalanced” force is coming. And with financial markets, forces are everywhere and changing by the tick. The best performing sectors this period can be the worst in the next one. Hence, betting on the top performers based solely on returns tend to yield erratic and unstable results.

Contrarian Based Measures

This is the opposite of momentum. In a contrarian approach, you bet on the laggards. It is a bit like playing catch up. But again, it all depends on what is the flavor of the moment. A laggard can remain a laggard for quite a while. Performance, again, can be unstable over the long term.

As a side track, the most reliable contrarian indicator is probably to gather a sizable group of newbies. Get them to trade real money on the same securities. Then when most of them freaked out of a position due to losses, that is when you make the grand entrance. How do I know? Because I was once one of those “reliable” newbies in my early days.

Risk-Based Measures

The emphasis on risk is often absent in the retail scene. As a subject, risks seem dry, boring, and is a topic dampener, unlike returns. The latter brings about excitement as it relates directly to how fat their wallet is. People prefer to talk about future potential and how much they can make rather than how much they can lose. But, whether we like it or not, risks are part and parcel of the equation. And if you intend to stay in the game for the long term, you got to take a serious look at it.

Performance of Sector Rotation Strategies

Let’s see how the various Sector Rotation strategies based on the different measures stack up against each other. On top of that, let’s throw in an equal weight Sector Rotation strategy as a comparison. Here is a summary of how they performed from 2005–2020 (up till July 2020).

From the results, risk-based measures seem to have an edge against the rest. It yielded more returns, lower volatility, and smaller drawdowns. In terms of the Sharpe ratio, it is clearly a notch above.

Hedged Sector Rotation System

But, of course, as with all long-term stock strategies, you can’t run away from the grim prospects of a major bear market. It is easy to accept that we have no control over it. But it is a harder pill to swallow to accept the fact that neither can we predict when it will come, how deep it will go and how long it will last. We can embrace it and do nothing. But that leaves us at the mercy of the market if a crisis hit especially during the final leg of our investment journey. That can mean retiring with a million, assuming that’s the target or less than half of that. Alternatively, we can mitigate such risks by hedging it with an appropriate asset and sizing rule.

See how an appropriate hedge applied to the Sector Rotation strategy using risk measures impact the performance. This is one of the online strategy courses we teach.

Conclusion

The market is always changing. Surprises are everywhere. We just had the shortest bear market in history this year triggered by a global pandemic. In a span of a few months, US stock markets are back up above and making new highs. We might see more short and drastic bursts of turbulence every now and then in the times ahead. I might be wrong, But in any case, it is always prudent to diversify and spread out your bets. And I don’t mean just across assets or geographical regions, but strategies as well.

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Stock Sector Investing Via Quantitative Modeling In Excel

Originally published at https://investmentcache.com on September 1, 2020.

Finance | Investments | Writing | Blog https://investmentcache.com

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