A Sector Rotation Trading Strategy You Can Follow

If you watch any one of the business news channels for more than an hour a week, you are likely to hear an expert proclaim that investors are moving money in or out of particular sectors. They might say “money is flowing out of financials and into gold mining stocks” for example. While it seems statements like this require actual knowledge of what other investors are thinking, that really isn’t the case. Sometimes the comments are based on observations of money flow indicators and other times they might be based on a theoretical sector rotation model like the one shown below.

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This model was popularized by John Murphy, CMT. It attempts to tie the ups and downs of the business cycle to changes in the stock market. Under this model, we expect the stock market to lead the economy. When the economy is at the bottom of recession, in other words when economic conditions are at their worst with high unemployment, we should expect the stock market to be at a bottom and starting to move higher. Under this theory, the economy will eventually follow the stock market up. In a similar manner, a stock market top should develop when the economy is strong and unemployment is low. This model explains the popular saying that “bull markets climb a wall of worry.” Bad economic news creates the bad news that a bull market ignores. It also explains why “good news is bad news” for the market since good economic news is prevalent when the market is in the early days of a bear market.

In the figure above, at the top of the model are the names of the sectors that are expected to do well based on where the economy is in the business cycle. As markets bottom, smart investors are looking ahead and buying. We expect technology stocks to be bottoming and leading the way higher. When it becomes clear the economy is in a recovery, investors should rotate into industrial stocks, since these will be the companies that are expected to do well in an economic expansion. As industrials become overvalued, the rotation continues with a move into energy stocks and consumer staples companies like packaged food companies. As the market tops, smart investors should be concerned about the impending bear market and they should be moving into defensive stocks with high dividends like utilities and financials.

That is an attractive model but each business cycle is different. According to the National Bureau of Economic Research, economic expansions have lasted as little as 10 months and as long as 120 months. Recessions have varied from 8 months to 65 months in length. Given the variability of the economy it’s doubtful the stock market follows a precise rotation strategy like the one shown in the chart above.

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In the markets, there is a rotation, but the rotation is impossible to forecast in advance. Investment managers running sector rotation funds usually rely on models that adapt to the current market environment to tell them where money is flowing. We can spot how large investors feel about different sectors with a simple strategy that relies on relative strength. These models can be difficult for individual investors to maintain because there can be a great deal of math involved. Let’s look at one of these more complex models and then we will build a simplified version that you can monitor with just a few minutes a month.

Any investment model starts with a group of stocks or ETFs that will be traded. For a sector rotation model, sector ETFs can be used. Nine tradable sector ETFs are shown in the next table.

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To decide which ones to buy, you could calculate the six-month rate of change (ROC) of each ETF once a month. The ETFs would then be sorted from the highest value ROC to the lowest. In this model, the top three funds would be bought. The next month, you would calculate the ROC again. If the funds you hold are among the top five ranked ETFs, you hold them. When one of the ETFs falls out of the top five, you sell that one and move into the highest ranked ETF you don’t currently own. Many managers follow a model like this, using more ETFs and calculating ROC or another relative strength measure on a weekly basis.

When the ROC of the ETF is rising faster than the broad stock market, money is flowing into that sector. When ROC is below average, money is leaving that sector. This is all we need to know to determine whether money is flowing in or out of a sector. It doesn’t require specialized knowledge of what investors are doing in real time or advanced math. Prices rise when there are more buyers than sellers and they fall when there are more sellers than buyers. By tracking the ROC of various sectors, we can spot whether there are more buyers or sellers.

Research has shown this simple strategy can beat the market but it does require some effort to follow. A simpler strategy does just as well, beating the market and reducing the risk. The results of the system as explained in Relative Strength Strategies for Investing by Mebane Faber are shown in the next chart.

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The rules are fairly simple. You use the same nine ETFs shown above for the ROC strategy. Once a month, you calculate the 10-month moving average (MA) for each ETF. This MA is available on a number of web sites. If the ETF is above the MA, you buy it or hold it if you already own it. You sell when the ETF falls below the 10-month MA. There are a couple more rules that deal with how to allocate capital. You invest equally in each ETF that is above the MA. If there are nine ETFs above the MA, you invest 11.1% of your capital in each one. If there are only eight ETFs above the MA, 12.5% of capital is invested in each.

If only 4 of the sectors are above the MA, then move 25% of your account into cash to protect capital. The remaining funds would be divided into equal parts and invested in the 5 funds trading above their 10-month MA. If 6 of the ETFs are below their MA, hold 50% of your account in cash and split the rest into the other three ETFs. If there are only 2 ETFs above the MA, allocate 75% of your account value to cash and split the rest into the 2 funds above their MA. When no ETFs are above their MA, you are 100% in cash.

The rules can seem confusing at first but are simple to follow. The results are worth the effort. On average, this strategy outperforms the S&P 500 by an average of 3% to 6% a year. Those extra returns can help you keep your retirement on track or meet any other financial goals you might have.

Can you do better? You can, but the risks will be greater. Instead of using ETFs, you could use individual stocks. For example, you could use one of the smaller holdings in the ETF. You could rank the top ten ETF holdings by ROC, buying the top ranked stock instead of the ETF. But owning one stock will always be riskier than owning an ETF because ETFs are diversified investments. One stock carries more risk than a diversified investment.

Overall, many investors will find the simple 10-month MA strategy to provide sufficient upside potential while managing the risks that come with any investment.