Is Sector Rotation Signaling a Market Top?

by: Parsimony Investment Research

My last few articles have been focused on sector rotations strategies because I believe that we are currently in a major sector shift that is signaling a market top.

In "Can Investors Use Sector ETFs to Outperform the Market?", I compared the returns of the S&P 500 Index (NYSEARCA:SPY) with a Sector Basket made up of the 9 Select Sector SPDRs (equally-weighted). I used this simple example to prove that there is in fact "edge" in being overweight the strongest sectors and underweight the weakest sectors.

The first step in creating a profitable investment strategy is identifying the "edge" (this is the easy part), but it is useless unless you can create a systematic strategy to consistently extract that "edge".

That being said, let's take a look at a relative strength analysis of the 9 Select Sector SPDR ETFs to identify the strongest and weakest sectors.

Sector Relative Strength

The table below compares the relative strength (price percentage change) of each sector vs. the S&P 500 Index (SPY) over the preceding 4-week, 13-week, 26-week, and 52-week periods.

By looking at the table above, it's pretty easy to identify which sectors are currently the strongest (Health Care, Utilities, and Staples) and which sectors are currently the weakest (Energy, Financials, and Materials).

It's also very important to look at the trend to understand the shift that is currently taking place. The Energy and Materials sectors tend to lead the market toward the end of a bull rally and Defensive sectors tend to lead the market higher when we are close to a market top.

You can see from the chart above that Energy and Materials have been the two strongest sectors for the preceding 26-week and 52-week periods. However, the sectors are now two of the weakest sectors over the past 4-week and 13-week periods. Conversely, Health Care, Utilities, and Staples, were among the three weakest sectors over the preceding 26-week and 52-week periods...but are now the three strongest sectors over the past 4-week and 13-week periods.

This Isn't Rocket Science, People!

Sector Rotation is definitely not a new concept and you can typically see it coming from a mile away. We are nearing a market top.

Below is a good graphical representation of the Sector Rotation concept. Notice that the shift I described above happens right at the peak of the market and economic cycles.

Legend: Market Cycle (red) | Economic Cycle (green)
This theoretical model is based on Sam Stovall's S&P's Guide to Sector Rotation and states that different sectors are stronger at different points in the economic cycle. The Market Cycle preceeds the Economic Cycle because investors try to anticipate economic effects.
How Can You Profit From the Shift?

Well, that all depends on what kind of investor you are. I'm a big believer that an investor needs to establish (and trade) a plan that fits their personality and situation. For example, if you have a low risk tolerance and don't have a need for "action", then you shouldn't be investing/trading the same plan as someone with a higher risk tolerance and a need to be an "active" participant in the market. Regardless of what type of investor you are, you need to "plan your trade, and trade your plan" (it sounds cliche, but it's the truth!).

I also would like to preface that this sector rotation strategy should only complement your broader portfolio asset allocation strategy (i.e, this strategy should only be used for your pre-determined domestic equity exposure). Clearly an equity market top and subsequent decline will affect every major asset class in your portfolio and I suggest that you plan appropriately.

Low Volatility Strategy (lower risk tolerance)
- I recommend getting defensive with your portfolio by getting overweight the Health Care, Utilities, and Consumer Staples sectors. If you are using ETFs, I would be overweight XLV, XLU, and XLP (the average dividend yield of these three ETFs is about 3.0% and they should hold up relatively well in a downturn). In addition, I would be underweight or completely flat the other sectors.
If you like individual stocks, I would choose companies in these three defensive sectors that have strong balance sheets and high dividend yields. I wrote an article last week highlighting some specific consumer staple stocks that should weather the storm.

Note: If you are extremely risk averse and capital preservation is your number one goal, I wouldn't be shy about taking all of your equity chips off the table right now.

High Volatility Strategy (higher risk tolerance)
- I am actually dedicating an entire article to the High Volatility Strategy (which will be my next stay tuned). The High Volatility Strategy involves shorting certain sectors and using levered ETFs to maximize your return.

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