Both sector rotation and risk appetite are well known phenomena in financial markets. Simply put, investors favor different sectors or asset classes during different phases of a business cycle. Both create profitable opportunities if investors know which phase it is in a business cycle. However the problem is that macro economic trends are clear only in hindsight. We take a forward-looking snapshot of the current business cycle with the help from the predictive power of our ETF ranking system.
On the surface, sector rotation is a phenomenon that investors favor certain sectors in certain phases. But the underlying driver is that certain phases benefit certain sectors financially. Investors are simply attracted by sectors' relatively better financial performance.
Business Cycle (Curtsey to MarketScalpel.com)
In a late recession phase, bad debts are purged out and macro business conditions stabilize. With bad debts being purged out, banks start to loosen loan standards and initiate new loans. An accommodatingly low funding cost also helps banks earn outsized profits. Without debt pressure, consumers are more comfortable with discretionary spending. Thus both financials and consumer discretionary sectors start to generate rosy earnings.
Then the earnings flow upstream along the food chain. Technology sector benefits in an early expansion phase as discretionary spending from both businesses and consumers brings up technology upgrade. While technology companies ramp up production, demand rises for raw materials and machinery, propping up materials and industrial sectors in a middle expansion phase.
As a booming economy encourages consumption, earnings flow to the energy sector in a late expansion phase. Earnings also spill over to consumer staples and healthcare when consumers don’t mind to spend more on non-discretionary items. Finally it reaches utilities. Utilities’ expansion requires heavy capital investment so it is delayed a little bit.
Unfortunately when utilities start to receive new capital, it often indicates that investors couldn’t find any growth opportunities and have to settle with utilities’ boring return on capital. Economic growth most likely stalls and an early recession phase is around the corner.
Risk appetite is similar. Superficially investors are aggressive in a bull market and chase companies that generate rich incomes, while they are conservative in a bear market and hide in companies with solid balance sheets. Still, the underlying force is companies’ financial performance.
A piece of asset is worthless if it cannot generate any income. Even in liquidation it fetches no buyers. Rational investors wouldn’t buy anything that couldn’t bring in profits. A balance sheet is solid whenever it generates stable incomes. When investors hide in companies with solid balance sheets, they are actually after the companies’ stable incomes. Indeed, stable incomes are preferred in a recession when income-oriented companies’ earnings power collapses.
It should be noted that sector rotation and risk appetite are interlaced with market behavior. Investors anticipate things and more often than not they follow their anticipation. If many investors anticipate a recession, they will switch to defensive sectors and assets, which will temporarily pop up their prices.
Actually this was what happened recently. But if investors’ anticipation does not materialize, they will switch back. Already, defensive sectors underperformed the market last week, probably signaling that money started to flow out.
A natural business cycle can be intervened by monetary and fiscal policies as well. Monetary stimulus can inflate financial firms, and inflation will lift materials. Stimulus is temporary but its effect can be long lasting.
Since investors are lured by companies’ financial outcomes, we are able to decipher where we are in a business cycle if we know which sectors and asset classes are the most attractive. For this we consult the predictive power of our ETF ranking system. Key attributes of the ranking system are summarized below. Details can be found in our methodology article: “ETF Ranking: A New Fundamental Approach That Drives Short-Term Return."
The ranking system is based on fundamentals. Individual stocks are ranked by their valuation, financial condition and return on capital. The rank of an ETF is calculated to be the weighted average over the ranks of stocks in its portfolio.
It has predictive power. The ranking system drives short-term return. We observed that stocks with higher ranks had a strong tendency to outperform those with lower ranks over a period of one week. The data show that moving up 10 rank points translates to an extra annualized return of 1.7% in the past 10 years, if ranks range from 0 to 100. As a mater of fact, the S&P 500 Index returned an annualized 2.5% in the same period.
To quantify sector rotation, we rank the nine SPDR sector ETFs and map them onto the sector rotation roadmap. Offensive sectors are in green and defensive sectors are in red.
ETF Rankings for Sector Rotation
In general, sectors belong to expansion fetched higher ranks than did sectors belong to recession, indicating that we are in an economic expansion. However, both the top ranked offensive and defensive sectors – energy (XLE) and healthcare (XLV) – belong to late expansion phase. Thus we are mostly likely at the end of the expansion, though it may still last for quarters or years. A warning sign of recession would be when utilities (XLU) replace healthcare to be the top ranked defensive sector.
A quick look at risk appetite is through the ranks of the four major index ETFs. On the safest end we pick the Dow Jones Industrial Average (DIA) and on the riskiest end we pick Russell 2000 (IWM). Nasdaq 100 (QQQ) is packed with high-tech companies and is more growth-oriented than S&P 500 (SPY). Currently Nasdaq 100 is ranked the highest, meaning that risk appetite moderately tilts towards risky assets.
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We also rank ETFs representing different market caps and growth and value stocks. We use growth and small caps to represent risky assets, and value and large caps to represent safe assets. For growth we use the average rank of IWF and IWO. For value we use the average rank of IWD and IWN. We choose ELR, MDY, and SLY for large caps, mid caps, and small caps, respectively. Then we map them onto a matrix with each cell being the average rank of categories on its corresponding row and column.
ETF Rankings for Risk Appetite
The top right cell – the riskiest – of the matrix fetched the highest rank while the bottom left cell – the safest – fetched the second lowest rank. The difference of their ranks is only around 10 points. Again the matrix shows that risk appetite moderately tilts towards risky assets.
Our ETF rankings for sector rotation and risk appetite suggest that we are in a late expansion phase and risk appetite is moderately lifted. Investors want to overweight risky assets, such as offensive sectors, growth, or small caps, but use caution.
This is an adapted excerpt of our paid ETF Ranking Newsletter dated to Jun. 18th, 2011.
Disclosure: I am long XLE.
Additional disclosure: I'm also short XLF