Relative Momentum and Sector Selection

 |  Includes: XLB, XLE, XLF, XLI, XLK, XLP, XLU, XLV, XLY
by: Jonathan Selsick

This is the second of a three part series of articles about top down portfolio construction using relative momentum. Part one compares foreign ETF momentum and part three compares size and style momentum. The analysis is presented in a unique time series heat map visualization simplifying the process of sector selection.

The Value of Sector Rotation

The first part of the table shows the annual returns for each sector ETF and the returns of the S&P and an equal weighted sector average. Below that, each sector is ranked from 1 to 9 in order of performance (1 being the best, 9 being the worst) and shaded from green (best) to red (worst).

  • The ranking of sectors changes frequently from year to year and in general, no sector stays in the same ranking range for more than two years. Each sector has its moment to outperform.

  • The difference between the best and the worst performing sector averaged a staggering 42% per year.

  • The top three performing sectors as a group outperformed the S&P by an average of 16% per year. Pick the top three sectors and you could outperform most professional money managers every year.

click to enlarge
Table 1. SPDR Sector Performance AnalysisClick to enlarge

Visualizing Momentum

Looking at sector momentum relative to the S&P or an equal weighted sector average over time provides a lot of clarity to the task of sector selection.

To demonstrate, we analyzed each sector ETF's monthly returns relative to the monthly return of the equal weighted sector average and classified the momentum into one of five stages. We used three moving averages to make the momentum determination; 1 month, 3 months and 10 months. Note that we are looking at monthly returns relative to the equal weighted average - not absolute returns.

Momentum is classified on a scale of 1 to 5 as follows:

Momentum of 1.0most bearish / negative momentum vs the index (dark red).
The 1 month average is below the 3 month average, and the 3 month average is below the 10 month average.

Momentum of 5.0most bullish / positive momentum vs the index (dark green).
The 1 month average is above the 3 month average, and the 3 month average is above the 10 month average.

The two columns on the right show the momentum of the S&P and the equal weighted average. On the left, overlaid above the date in red, is the official start and end date of each recession according to the National Bureau of Economic Research (NBER). The time series graphic is split into two columns for ease of visualization.

Sector Heat Map Time Series VisualizationClick to enlarge

While you can explore the table yourself, I will highlight some examples from the past two years to familiarize you with how to read it:

  • Consumer Discretionary (XLY) started to outperform half way through the recession in September 2009 and did so up until December 2010. It has since started to underperform the index.

  • The defensive sectors of Consumer Staples (XLP), Health Care (XLV) and Utilities (XLU) outperformed the index during the recession, but have generally been laggards since the recession ended, except for the few months subsequent to the Flash Crash in May of 2010.

  • The past six months have been dominated by three sectors; Materials (XLB), Energy (XLE) and Industrials (XLI). Technology (XLK) and Discretionary (XLY) seem to have exhausted their outperformance in November 2010. Industrials (XLI) is experiencing its longest uninterrupted period of outperformance seen over the past 12 years (19 months and going strong).

  • Financials (XLF) have not done much for the past year. I expect their time could be coming soon.

  • Utilities (XLU), while generally defensive, have exhibited periods of outperformance which were not in recessionary environments, so its possible they may show some momentum soon too.

  • Notice how certain sectors, like Materials (XLB) and Energy (XLE), seem to have long sustained rallies once their momentum gets going.

Hopefully this table helps you see the big picture and to focus on those sectors that are beginning to outperform the index, and avoiding those that either dont perform in a bull market, or have already run their course. Keep an eye on how the chart develops each month so that hopefully you can piggyback on sectors as they begin their rallies. Good luck picking those top three sectors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.