Short-term traders and long-term investors alike have flocked to exchange-traded funds (ETFs) in large part because of the exposure they provide to different segments of the economy. Investors can now buy a single ETF providing diversified exposure to a specific area of the global economy, which means strategies that were once mostly reserved 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 conditions. There are three general rotation strategies investors can use to attempt to capitalize on these patterns.
Be sure to also read How to Swing Trade ETFs.
The Appeal Behind Sector Rotation
Not all securities move together at the same time, at least not with the same magnitude. Business or economic cycles, seasonal or calendar tendencies, as well geographic location can cause certain stocks to perform better than others. The best-performing stocks will change as the cycles progress.
Sector rotation strategies attempt to determine which segments of the global economy are likely to be the strongest, investing in 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 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. Also, since the investor must actively manage the portfolio, commissions will increase along with the time dedicated to market analysis. Nonetheless, this approach will likely take up less time than researching multiple individual stocks.
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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 will therefore bottom out (and head higher) before the economy begins to pick up. Similarly, stocks will top out before the economy begins to slow down.
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 health care (XLV ), as the broader market begins to decline. As the market gets weaker, utilities (XLU ) generally outperform. 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.
See also the 5 Most Important Chart Patterns For ETF Traders.
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.
Strategy 2: Seasonal
During the calendar year investors can also rotate into sectors that benefit from yearly events.
“Driving season” positively impacts the energy industry. During the summer months more travel and driving occurs, which may lift prices at the pump and increase margins for refiners. Demand increases may help those in the exploration and production side of the business. To take advantage, buy the Energy Select Sector SPDR ETF (XLE ) or the SPDR Oil & Gas Exploration and Production ETF (XOP ) if the sector begins to creep up in anticipation of the driving season. Exit the sector when momentum begins to wane and the season winds down.
By that time, there are other sectors to look at. As September approaches, retailers generally see a jump in sales due to students returning to school. This sector is tradable via the SPDR S&P Retail ETF (XRT ). As shopping ramps up during the Christmas season, this sector also sees buying interest, but to what magnitude is determined by the overall consensus of whether it will be a busy or quiet shopping season.
See also 17 ETFs For Day Traders.
Overall market conditions may overshadow such tendencies. If the broader market, gauged by the S&P 500, is in decline, the relatively strong performance of these sectors during these times of year may not overcome the general selling pressure. Therefore, wait for the sectors to show strength in anticipation of these points on the calendar before buying, instead of simply assuming the sector will perform well.
Strategy 3: Geographic
Looking to markets outside your home country can be a lucrative strategy, as there are often global markets that may be seeing comparatively stronger growth. Before ETFs, investing in these global markets was trickier, but now investors can simply monitor which country ETFs are performing the best and buy those funds. As momentum begins to wane, exit the trade and look for another country that is performing better.
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During 2012, the MSCI Singapore Index Fund (EWS ) performed well, gaining close to 26% relative to the SPDR S&P 500 (SPY ), a gain of roughly 13% on a price performance basis. The MSCI Mexico Index Fund (EWW ) performed even better, racking up a price gain of 31%.
Investors can also invest in a category, such as “emerging markets". These markets are in their growth phase, and while the ups and downs can be volatile, strong trends can bring big rewards. To invest in a basket of emerging countries, look to the popular FTSE Emerging Markets ETF (VWO ) or the MSCI Emerging Markets Index Fund (EEM ). See also the Complete List of Emerging Markets Equities ETFs.
The Bottom Line
Whether you are looking to capitalize on economic cycles, seasonal tendencies, or geographic trends, ETFs provide a simple and direct way to accomplish your objectives through a rotation strategy. As with any strategy there are risks, and it is important to gather information on the markets and ETFs you are investing in before making your purchase. Sector rotation strategies generally position the investor in the strongest segments of the global economy, but trends change. When the sector you are in starts to turn, it’s time to exit the position and look for another segment that is performing better. This may incur commissions and some active management of the portfolio, but if done correctly, the returns should more than compensate.
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Disclosure: No positions at time of writing.