Why The Technology Sector ETF XLK Is Riding High

Sep.19.11 | About: Technology Select (XLK)

The Technology SPDR ETF (NYSEARCA:XLK) is ranked at the top among sector ETFs and that indicates the economy is likely to expand on its own.

Readers of mine should be familiar with the long XLE / short XLF strategy I’ve been advocating. The strategy is based on my fundamental ETF ranking system that has predictive power to tell which ETF is likely to outperform and which one is likely to underperform. For months, XLE was the top ranked offensive sector ETF and XLF was the bottom one. The year-to-date return of the simple strategy is around 20%.

ETF

Rank as of 9/17/11

Rank as of 9/10/11

XLK

70.86

63.79

XLB

66.29

60.30

XLE

59.60

67.27

XLI

49.84

47.78

XLY

46.98

44.43

XLF

13.14

15.86

XLU

24.80

30.53

Click to enlarge

But things changed this weekend. As shown in the table above, XLK jumped up to the first place. According to their ranks, XLK is now a better choice than XLE. Utilities sector (NYSEARCA:XLU) is defensive. I list it here for other purposes, which will be detailed later.

The changes of the ranks are linked to the well-known sector rotation phenomena. It’s observed that certain sectors outperform during certain phases of a business cycle. Investors following the sector rotation roadmap will be rewarded handsomely. The problem is that macro economic trends are clear only in hindsight. In a previous article I introduced a method to combine the predictive power of the ETF ranking system and the sector rotation roadmap to gain insights into where we are in a business cycle.

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. Because the ranking system ranks ETFs by their valuation, financial conditions, and return on capital, a sector with a better rank has more solid fundamentals and often delivers a better financial result. Mapping the ranks of sector ETFs on the sector rotation roadmap produces a forward looking snapshot.
Sector Rotation Roadmap as of Sep. 17th, 2011
Click to enlarge

As of today, the sectors associated to Expansion generally have better ranks than those associated to Recession. The chart looks like a tent propped up by a single pole centered at Early Expansion. The further away from the Early Expansion a sector is, the worse the rank of its respective ETF. The bottom ranked XLF locates in Late Recession and the second lowest XLU locates in Early Recession. All the pieces point to an emerging economic expansion.

The roadmap was in a much different shape three months ago. At that time it still looked like a tent propped up by a single pole, but the pole was centered at Late Expansion. A natural business cycle can be intervened by monetary and fiscal policies. Monetary stimulus can cause inflation and inflation will lift materials and energy temporarily. We believe that three months ago the heightened ranks in Late Expansion were largely a result of the Fed’s Quantitative Easing. After the Fed turned off the life support, the economy started to move forward on its own. If that is the case, this coming expansion is organic.

Action Plan

The long XLE / short XLF strategy was market neutral. I recommended a market neutral strategy months ago because the sector rotation roadmap indicated that we were in Late Expansion. As now we are in Early Expansion, investors can be more aggressive and go straight long XLK.

Another reason I ditched the leg of short XLF is that XLF’s rank dipped below 15. According to my experience, going short anything below 15 is much more risky. Stocks and ETFs ranked below 15 are usually orphans discarded by the market. Only die-hard lovers are left to hold them and those lovers are not going to sell a single share. On the other hand, they are usually heavily shorted by speculators trying to squeeze out the last penny. If we are in Early Expansion and the market goes up from here, a giant short squeeze will send their prices through the roof.

An investor who wants to leverage on his portfolio can consider selling short XLU to fund the long position of XLK. By doing this, the investor earns the upside of XLK out of thin air.

We choose XLU for two reasons. First, it is defensive and has a beta only 0.6, meaning it moves much slower than the market. If the market goes up from here, XLK will rise much faster than XLU does. Second, its rank is only 24.8, 46 points below that of XLK. Because 10 rank points translated to 1.7% annualized return, our expected annualized return is 1.7% x 46/10 = 7.8%. It is noteworthy that this number is derived from the past 10 years. The S&P 500 (NYSEARCA:SPY) returned merely an annualized 2.5% in that period. A 7.8% return is really more than three times the market return. That said, historical returns do not guarantee future performance.

Disclosure: I am long XLK. and short XLU.