Short-term traders and long-term investors alike have flocked to exchange-traded funds in large part because of the exposure they provide to different segments of the economy, including stock sectors, commodities, bonds, real estate and global markets. Investors can now buy a single ETF providing diversified exposure to a specific area of the global economy, which means strategies that were once reserved mostly for professionals are now accessible to everyone. One such strategy is sector rotation.
Equities often move in patterns, with certain types of stocks performing better in certain economic conditions, and other types of stocks performing better in other types of conditions. There are three general rotation strategies you can use to attempt to capitalize on these patterns.
What’s the Appeal?
Not all securities move together at the same time, or least not with the same magnitude. The business or economic cycle, seasonal or calendar tendencies as well geographic location can cause certain stocks to perform better than others, and which stocks perform the best will change as the cycles progress.
Sector rotation strategies attempt to determine which segments of the global economy are likely to be strongest, and then invest in the ETFs related to those specific markets. ETFs provide easy access to markets that were previously harder to invest in, such as commodities or a diversified basket of stocks from one stock sector. The allure is that, if successfully executed, the investor is always invested in the strongest sectors or ETFs and therefore should see higher returns than a basic diversified buy-and-hold strategy.
In order to realize a profit, however, the investor must sell the once-strong ETF when it begins to weaken, and then purchase another ETF that is expected to perform best over the next several months or years. This is where the drawbacks lie. In real-time trading it is not as easy to pin-point times to buy and sell different sectors as the theory implies.
And because the investor must actively manage the portfolio, commissions will increase as well as the time dedicated to market analysis. Nonetheless this approach will likely take up less time than researching multiple individual stocks.
Strategy 1: Economic Cycle
The economy moves from full recession to early recovery, to full recovery and back into early recession. This process may take many years to complete, but during this cycle the stock market will also be moving up and down. Stocks generally lead the economy, and therefore the stock will often bottom (and head higher) before the economy begins to pick up, and stocks will top out before the economy begins to slow down. [see How To Take Profits And Cut Losses When Trading ETFs]
Since stocks are the primary input, investors can simply watch the overall trend of the S&P 500 to determine which sectors are likely to perform the best.
According to research by John Murphy, discussed in his book “Intermarket Analysis,“ certain sectors perform the best during different phases of the market trend.
When the market is at a bottom, Consumer Discretionary stocks are usually the first to turn higher; investors can trade this sector using the Consumer Discretionary Select Sector SPDR ETF (XLY). This upturn is generally followed by an uptick in Technology (XLK), then Industrials (XLI) and then Basic Materials (XLB). When the Energy sector (XLE) is the top performer, it is often a sign the stock market is topping out.
Buying interest then typically moves into the Staples (XLP) sector and Healthcare (XLV) as the broader market begins to decline. As the market gets weaker, Utilities (XLU) generally outperform, and finally money begins to flow into Financials (XLF)–when this occurs it is usually a sign that the broader market is close to a bottom.
This pattern provides a general outline of which sectors will perform best, and in what order. The strategy is to invest in the strongest sector ETFs, then when momentum begins to wane, exit the position and move into the sector that is showing the most potential. The order may change during any given cycle, so focus on actual sector performance and not just this historical tendency.
During a bear market it is important to remember that all the sectors may decline. Even if one sector is performing better than others, be aware that the sector ETF may still fall, resulting in losses.