How to Spot a Sector Rotation with ETFs

by on April 15, 2014 | ETFs Mentioned:

Making the right call on whether we’re headed for a bull or bear market is only half the battle; knowing which sectors are poised to outperform, given the prevailing economic conditions, is how many professional money managers “beat the market.” Commonly referred to as sector rotation, this timeless investing approach revolves around picking market leaders at different turning points throughout the business cycle.

This sort of strategy requires more than a surface level understanding of the business cycle and the underlying economic forces; thoughtful analysis and careful planning are necessary before pulling the trigger on the sectors that are most favorably positioned to outperform during each phase of the cycle [see also 3 Sector Rotation Strategies ETF Investors Must Know].

Investors can start to hone their business cycle investing skills by first understanding how to identify when a sector rotation is in fact taking place. This process can at times be intimidating, even for seasoned veterans. Below we’ve outlined a simple framework along with a real life example that can be adapted to virtually any scenario.

Ask the Right Questions

Sector rotation is about being invested in the sectors that are poised to continue outperforming, as well as identifying those that are on the cusp of taking leadership. To succeed in both of these endeavors, investors must start by asking the right question that gives them a feel for the current environment: who are the current market leaders?

Second, investors should keep in mind that rotations more often than not occur during broad market corrections. Because of this, it’s important to understand any fundamental drivers behind the pullback, which means answering the question: what led to this particular market decline?

Lessons Learned from the Taper Tantrum

Let’s ask the two questions from above in the context of the so-called “taper tantrum” that spanned from 5/22/2013 to 6/24/2013. Remember, our goal here is to identify any changes in leadership that investors could have taken advantage of – this example assumes perfect hindsight for explanation purposes [see also 3 Market Valuation Indicators ETF Investors Must Know].

First, let’s determine the market leaders at the time. To do this, we’re going to look at trailing 60-day returns for all nine sectors, as represented by State Street’s SPDRs lineup, leading up to the start of the correction on May 22nd. Next, we want to analyze the fundamental drivers behind the pullback. Lastly, we want to confirm any rotation that may have taken place by comparing the sector returns 60 days following the end of the pullback on June 24th. Consider the findings below:

Now let’s re-address our three questions:

  • The three leaders outperforming the broad market, as represented by the SPDR S&P 500 (SPY, A), leading up to the taper tantrum in order of descending relative strength were: Health Care (XLV, A), Consumer Discretionary (XLY, A), and Financials (XLF, A).
  • The reason for this pullback was fear of inevitably rising rates; the Fed’s mention of dialing back stimulus on 5/22/2013 was in hindsight a positive message that the economy is recovering well on its own; however, the initial response was fierce selling pressures, especially across interest-rate sensitive securities.
  • There was indeed a sector rotation during this pullback, one that favored growth-sensitive sectors over non-cyclical ones. This is evidenced by the change in leadership among the top three sectors, which after the pullback were Industrials (XLI, A), Discretionary (XLY, A), and Materials (XLB, A) in descending order. Furthermore, notice how non-cyclical sectors like Staples (XLU , A) and Utilities (XLU, A) lagged far behind the rest of the group, once again confirming that the rotation favored more growth-sensitive securities.

Let’s put this is all into context. The taper tantrum led to a sell off in the near-term, but the longer-term message that the Fed sent was clearly one of improving economic growth on the horizon; this is evidenced by the sector rotation that took place during the pullback, which ultimately ended up favoring cyclical sectors more so than defensive ones.

The Bottom Line

Sector rotation refers to favorably positioning your portfolio at each turn in the business cycle. By over-weighting exposure to sectors that are more favorably positioned to outperform the broad market over the coming months, investors can greatly improve their portfolio’s risk-adjusted returns over time. Remember that a successful sector rotation strategy requires diligent research and disciplined execution in addition to constantly monitoring the prevailing economic environment. 

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Disclosure: No positions at time of writing.