As part of the recurring debate on the role of sector rotation in the process of asset allocation, there is a growing discord between the building of "all-weather" portfolios and the traditional dynamic sector repositioning based on the cyclical position of the economy.
Equity indices' sub-sectors perform differently depending on the current stage of the business cycle: early stage, mid-growth, late-stage, and recession. Even though it is quite easy to characterize the different phases of the economy after the fact, based on a limited set of indicators (credit, jobs, industrial production, monetary policy…), the difficulty comes in assessing the current stage. Add to this the problem of building efficient tools for identifying the turning points: credit spreads and expected inflation have not proven robust. Some analysts use monetary policy shifts as indicators for sector rotation but the current ZIRP combined with quantitative easing makes this framework useless.
Here I use sector rotation not as a tool for enhancing portfolio performance but as an indicator of where the market stands. More specifically, I build early, mid, late and recession portfolios based on the traditional asset-management matrix below.
I build long/short portfolios based on the monthly S&P 500 returns of each subsector, weighted by their matching GDP weight. The "early" portfolio is thus long financials, consumer discretionary, info/tech, industrials and materials and short energy, telecom and utilities. Each sub-sector is weighted according the share of its associated GDP in total GDP, not its weight in the S&P index.
The chart below shows that the early portfolio outperforms during recovery times, while the recession portfolio outperforms during the worst period of any recession.
(click to enlarge)
Interestingly enough, the convergence of the early and recession portfolio returns has historically been a leading indicator of recession or economic slowdown (see for instance: 1994, 2000, and 2007).
As of today, the information provided by the following charts is interesting: on a one-year and six-month basis, the early cycle portfolio is outperforming. This could be seen as a positive sign in the short run.
(click to enlarge)
Nevertheless, the convergence of returns should signal caution. There have been false alerts before (late 2011), but it could be considered a sign for a tactical move to the sidelines.
The charts suggest that markets are still overplaying the recovery style, but the gears may be shifting, as the recession portfolio gains traction, and early and recession portfolios are converging. I would reduce exposure on SPY at this stage.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
